prioritizing economic growth: enhancing macroeconomic ...prioritizing economic growth: enhancing...

UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT

G-24 Discussion Paper Series

UNITED NATIONS

Prioritizing Economic Growth:Enhancing Macroeconomic Policy Choice

Colin I. Bradford, Jr.

No. 37, April 2005

G-24 Discussion Paper Series

Research papers for the Intergovernmental Group of Twenty-Fouron International Monetary Affairs

UNITED NATIONSNew York and Geneva, April 2005

UNITED NATIONS CONFERENCEON TRADE AND DEVELOPMENT

INTERGOVERNMENTALGROUP OF TWENTY-FOUR

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iiiPrioritizing Economic Growth: Enhancing Macroeconomic Policy Choice

PREFACE

The G-24 Discussion Paper Series is a collection of research papers preparedunder the UNCTAD Project of Technical Support to the Intergovernmental Group ofTwenty-Four on International Monetary Affairs (G-24). The G-24 was established in1971 with a view to increasing the analytical capacity and the negotiating strength ofthe developing countries in discussions and negotiations in the international financialinstitutions. The G-24 is the only formal developing-country grouping within the IMFand the World Bank. Its meetings are open to all developing countries.

The G-24 Project, which is administered by UNCTAD�s Division on Globalizationand Development Strategies, aims at enhancing the understanding of policy makers indeveloping countries of the complex issues in the international monetary and financialsystem, and at raising awareness outside developing countries of the need to introducea development dimension into the discussion of international financial and institutionalreform.

The research papers are discussed among experts and policy makers at the meetingsof the G-24 Technical Group, and provide inputs to the meetings of the G-24 Ministersand Deputies in their preparations for negotiations and discussions in the framework ofthe IMF�s International Monetary and Financial Committee (formerly Interim Committee)and the Joint IMF/IBRD Development Committee, as well as in other forums.

The Project of Technical Support to the G-24 receives generous financial supportfrom the International Development Research Centre of Canada and contributions fromthe countries participating in the meetings of the G-24.

PRIORITIZING ECONOMIC GROWTH:ENHANCING MACROECONOMIC POLICY CHOICE


Professor, Department of Economics and School of International ServiceAmerican University, Washington, DC

G-24 Discussion Paper No. 37

April 2005

viiPrioritizing Economic Growth: Enhancing Macroeconomic Policy Choice

Abstract

This paper spells out a logic for increasing macroeconomic policy space in order to prioritizethe goals of growth, employment creation and poverty reduction.

First, there is the need to create additional policy instruments so that a greater number ofpolicy goals can be addressed. Frequently, real economy goals get partly crowded out by financialobjectives because there are too few instruments for too many goals. Second, the calibrated useof policy tools by degrees of commitment, deployment and assignment can create space fordifferent policy-mixes. Selective capital controls, intermediate exchange rate regimes, and somemonetary policy autonomy create the policy space within which a variety of policy combinationsand mixes are possible and a greater number of instruments are available. Prioritization of realeconomy goals becomes both more feasible and more likely with a broader range of policyalternatives. Third, along with selective use of capital controls, fiscal policy-based stabilizationinstead of exchange rate-based stabilization delinks the exchange rate from the goal of internalfinancial stability to which it is yoked in a regime of fixed exchange rates. This delinkage enablesthe use of intermediate exchange rate regimes (soft pegs and managed floating). The use ofthese regimes in �the missing middle� between fixed and flexible exchange rates creates policyspace where different mixes are possible generating a greater range of policy alternatives. Fourth,prioritizing real economy goals is also facilitated by the design of a larger strategic frameworkfor accelerated development including institutions, norms, behaviours and governance. The largerstrategic framework mobilizes more assets and power toward a dynamic growth trajectory thatcreates a more favourable context for macroeconomic policy. The impact of macroeconomicpolicies on growth, employment creation and poverty reduction is likely to be stronger whenthey are part of a wider effort to marshal resources for accelerated development. The examplesof the East Asian success stories provide the evidence for this conclusion.

These four steps in the logic for increased macroeconomic policy choice � new policy tools,selective and pragmatic use of capital controls and exchange rate intervention, fiscal policy-based stabilization, and strategic frameworks � reinforce each other in their capacity to createmore policy space.

ixPrioritizing Economic Growth: Enhancing Macroeconomic Policy Choice

Table of contents

Page

Preface ............................................................................................................................................ iii

Abstract ........................................................................................................................................... vii

I. Policy objectives and policy instruments ............................................................................... 2

II. Closed versus open economies ................................................................................................ 2

III. Floating versus fixed exchange rate regimes ......................................................................... 3

IV. Selective pragmatism ............................................................................................................... 5

V. Fiscal policy-based stabilization ............................................................................................. 6

VI. The exchange rate debate and policy space ........................................................................... 8

VII. Selective use of capital controls ............................................................................................... 9

VIII. From populism to orthodoxy to heterodox policy packages .............................................. 11

IX. The East Asian experience: strategic frameworks for macropolicy .................................. 13

X. Conclusions: the logic of enhanced macropolicy space and its implications .................... 15

Notes ........................................................................................................................................... 16

Bibliography ........................................................................................................................................... 17

List of charts

1 Assignment of policy tools to policy goals under floating exchange rate(*) andfixed exchange rate (#) regimes .................................................................................................... 3

2 Trilemma ....................................................................................................................................... 6

3 Assignment of policy tools to policy goals under intermediate exchange rate regimes (X) ........ 7

4 Illustrative assignment of �new� policy tools to policy goals as a means of prioritizingeconomic growth as a goal of macropolicy ................................................................................ 12

List of tables

1 Type of exchange rate regime applied in different categories of countries .................................. 9

2 Use of capital controls: 1996�2002 ............................................................................................ 10

Recent economic policy experience in devel-oping countries has led many to conclude either thatthere is no �policy space� for economic policy al-ternatives and/or that mainstream economic policypractice is highly deflationary. The lack of choicewould seem to weaken democratic process in devel-oping countries limiting the role of public discussion,debate and decision in economic policy-making. Andthe perceived priority of financial stability over realeconomy objectives of economic growth and greateremployment feed a sense that there are biases in theglobalization process and in the international finan-cial institutions which appear to preside over it. Asa result, there are strong motivations for exploringthe degree of macroeconomic policy choice, bothfrom internal political and economic perspectives andfrom the point of view of the international debate.

This paper attempts to lay out a logic for thenotion that macroeconomic policy can indeed playa role in stimulating economic growth and employ-

ment, despite the many realistic constraints on itsconduct. The soundness of the argument is impor-tant to the international economic agenda and themechanisms for global governance, for if there isindeed no room for macroeconomic policy choice,then there is less reason to strengthen the �voice� ofdeveloping countries in the global governance. If�one size fits all�, then the boundaries on both de-bate and decision are tightly drawn undermining theneed to hear and accommodate differing perspec-tives on macropolicy in the international community.

However, recent experience also suggests thatfinancial stability is not sustainable without socialimprovement, and that poverty reduction and en-hanced equity are not sustainable without financialstability. Today, the IMF and the Lula administra-tion in Brazil both seem to recognize these inter-connected policy imperatives and to be locked in adance together in which the fate of each depends onthe other. As a consequence, being able to prioritize

PRIORITIZING ECONOMIC GROWTH:ENHANCING MACROECONOMIC POLICY CHOICE*


... while the new policy direction has successfully uprooted the previous regime it has failed toestablish a flourishing alternative. More worrying still, in terms of future prospects, has beenthe loss of policy autonomy, at both the microeconomic and macroeconomic levels, and thenarrowing of the room for policy manoeuvre. Rubens Ricupero, Secretary General of UNCTAD(UNCTAD, 2003: XII)

* This work was carried out with the aid of a grant from the International Development Research Centre, Ottawa, Canada.

2 G-24 Discussion Paper Series, No. 37

growth, employment, poverty reduction and equityare critical for the sustainability of policy reformefforts. Without a sense of policy options, nationalgovernments may be less inclined to participate inglobal integration and governance. The presidentsof Argentina and Brazil met in the fall of 2003 andsigned a �sweeping statement, dubbed the BuenosAires Consensus, as a rejoinder to the WashingtonConsensus�The statement promised to generatejobs, not just profit, and fight for fair, not just free,global trade� (Smith, 2003).

This paper deals with policy alternatives, policyconstraints and policy experiences. The first threesections develop the logic for enhanced policy spacedeveloped from the analytics of the assignment ofinstruments to objectives within open and closedeconomies and under fixed and flexible exchangerate regimes. The second set of three sections ad-dresses the pressure of markets on policy practice,especially fiscal policy, and the degree to which thereis policy space in the exchange rate policy debateand experience. The last two sections give an over-view of recent policy experiences in both LatinAmerica and East Asia in revealing limitations andopportunities for exercising macropolicy choice.

I. Policy objectives and policyinstruments

Tinbergen taught us that for economic policyto work, there needs to be at least as many policyinstruments as there are policy goals (Tinbergen,1956). This principle, as we shall see, is difficult toimplement in a world of multiple objectives andimposing constraints. Mundell helped carry this prin-ciple forward in the early 1960s when he articulatedthe idea of �assigning� each instrument of macroeco-nomic policy to different policy objectives in aneffort to achieve internal and external balance atthe same time, something that was at the time be-coming increasingly important due to the growingopenness of national economies to the world economy(Mundell, 1962: 70�77). As William Branson ob-served many years later, the Mundellian frameworknormally assigned fiscal policy to internal balance,by which was meant the reduction of inflation, whileexchange rate policy was assigned to the trade bal-ance or the current account, and monetary policywas assigned to foreign exchange reserves or thecapital account (Branson, 1995: 116).

This is at once an ingenious and problematicframework for it reveals even today the underlyingpolicy tensions at work which are driving both dis-couragement about policy space and debate aboutfuture policies. The deflationary bias implicit in thisassignment is clear. Contractionary fiscal policy isnecessary to bring down aggregate demand driveninflation. Contractionary monetary policy is neces-sary to keep the domestic interest rate higher thanthe world interest rate to attract foreign capital. Andexchange rate devaluations, which restrict importseven though exports expand, are necessary to shrinkthe trade deficit.

While these policies are effective means ofachieving financial stability, the entire set ofmacropolicy tools are essentially used up to avoidexcessive inflation and external imbalances leavingno tool remaining to assign to economic growth andemployment generation. There are essentially toofew instruments to achieve financial stability and eco-nomic growth at the same time. The 3x3 tool-targetmatrix leaves out the real economy goals of economicgrowth and employment generation (chart 1). Thisconundrum creates incentives for thinking about howto increase the number of policy instruments so thatreal economy objectives (growth and jobs) can beprioritized within the standard policy frameworkformulated by Mundell. It also reveals the need tothink creatively about how to manage economicpolicy trade-offs to preserve manoeuvring room forpolicy makers so they in fact have options andchoices. Preserving policy space seems all the moredifficult against the background of recent policyexperiences in several high visibility cases of eco-nomic policy crises in which there has been intensepressure to give up policy instruments, reducing thetotal number of instruments available rather thanincreasing them, making the challenge of address-ing real economy goals even more difficult.

II. Closed versus open economies

One way to get a grip on why the current policyconundrum is so vexing, is to think about theMundellian policy framework in closed economies.In closed economies, there are essentially only twomacropolicy instruments, fiscal and monetary policy.But there are only internal policy goals, since exter-nal targets are proportionately less important inclosed economies. Despite the presence of only two

3Prioritizing Economic Growth: Enhancing Macroeconomic Policy Choice

instruments, the absence of two goals for externalbalance means that there can be an internal pri-oritization of employment generation through eco-nomic growth as well as a goal for financial stabili-zation through reducing inflation. In this world oftwo tools for two domestic targets, fiscal policy couldbe assigned in a Keynesian way to employment andgrowth, while monetary policy could be assigned toprice stability. In a closed economy, the exchangerate is not important in determining domestic eco-nomic conditions because exports are a small shareof GDP. And, also, the tight linkage in open econo-mies between interest rates and the exchange rate isnot as rigid in relatively closed economies.

In open economies with flexible exchange rateregimes, expansionary monetary policy leads to in-terest rate declines, in which case the exchange ratemust rise (depreciate) to off-set the decreased returns

in the domestic market caused by looser monetarypolicy. Conversely, with contractionary monetarypolicy in open economies, higher interest rates resultinexorably in a lower exchange rate (appreciation)to equalize returns in all markets in a world of inte-grated capital markets and open capital accounts. Inopen as opposed to closed economies, the exchangerate is the shock absorber and adjustment mecha-nism that restores equilibrium when there has beena policy shift internally or a policy shock externally.This is one advantage of floating exchange rate re-gimes.

Open economies, nonetheless, face a more dif-ficult set of policy options than closed economiesboth because of the addition of the two external goalsof current and capital account balance, and also pre-cisely because in open economies with floatingexchange rates, the interest rate and the exchangerate are rigidly linked to each other so that a vari-ance in one forces an off-setting variation in theother.1 These two facts together mean that it is verydifficult if not impossible to assign monetary policyto an internal goal, whether price stability or em-ployment, because the rigid link to the exchange raterequires that monetary policy be assigned to exter-nal balance. Now, these facts push macropolicy backto the situation of too few instruments for too manygoals. In this situation common to open economies,the real economy goals of employment and growthtend to get sacrificed to the financial goals of defla-tion and correction in the balance of payments whichgenerally are more immediate and more pressing.External crises, depleting foreign exchange reserves,take precedence over any other priority.

III. Floating versus fixed exchangerate regimes

There are basically four types of exchangerate regimes: floating, fixed, pegged and managed-intervention regimes. Floating exchange rates aremarket determined. They have the advantage of be-ing very adaptive to changes in internal and externalcircumstances and the disadvantage of leading to po-tentially volatile exchange rates. Fixed rate regimes,such as currency boards, are usually agreed to forextended periods thereby having the advantage ofexchange rate stability which can play a major role inachieving price stability but the disadvantage of sur-rendering monetary policy autonomy. A pegged

Chart 1

ASSIGNMENT OF POLICY TOOLS TOPOLICY GOALS UNDER FLOATING

EXCHANGE RATE(*) AND FIXEDEXCHANGE RATE (#) REGIMES

Current CapitalPrice account account Economic

stability balance balance growth

Fiscal policy * # --------or -------- #

Exchange rate # # * #

Capital controls

Monetary policy *

Note: In floating rate regimes, the capital account isassumed to be fully open, i.e. monetary policy has tobe assigned to the capital account. Thus, the threemacropolicy tools are assigned to three targets, whichmeans that growth is in effect crowded out.In fixed exchange rate regimes, monetary policyautonomy is foregone and the capital account isassumed to be fully open removing capital controls asan instrument of macropolicy. In the trade-off betweenassignment to the current account and economicgrowth, fiscal policy tends to be assigned to externalbalance rather than internal growth. The exchange ratebecomes an anchor for achieving internal pricestability with spillover effects on external balance.


exchange rate regime is one in which the govern-ment establishes the exchange rate as a matter ofpolicy and the central bank intervenes in foreignexchange markets buying and selling foreignexchange to support the �peg� until the govern-ment shifts policy when it designates a new rate. Amanaged-intervention regime usually means theestablishment of a �soft� peg or dirty float, includingan exchange rate band (say, plus or minus 2.5 percent above and below a designated rate which mayor may not be announced) which the central banksustains by selective intervention in exchange andmoney markets.

The essential issue for the discussion here isthat the type of exchange rate regime chosen hassignificant implications for the degree of macropolicydiscretion open to governments. For example, in apegged exchange rate regime, the exchange rate be-comes a policy instrument whereas in a floating rateregime the exchange rate often becomes a policytarget which requires that monetary or fiscal policyor both discipline themselves in order to sustain thefloating rate at some reasonable level. It is the case(though it will not be demonstrated here) that onlymonetary policy is effective in floating rate regimesin stimulating growth in GDP. Fiscal policy forgrowth in floating rate regimes induces higher in-terest rates and exchange rate appreciation whichnullify the growth stimulus from expansionary fis-cal policy.

As a result, the policy problem in floating rateregimes is that monetary policy would have to dodouble-duty on both the internal and external frontsif growth were to be a priority. If fiscal policy isassigned to inflation, the exchange rate to the cur-rent account and monetary policy to the capitalaccount and the exchange rate, monetary policy cannot be assigned to internal real economy objectives.This is in effect a 3x4 tool-target situation in whichthe conundrum of too few instruments for too manygoals reappears in which growth is crowded out (con-figuration * in chart 1). Even though in floating rateregimes monetary policy �works� to improve con-ditions in the real economy by stimulating economicgrowth, it is pre-empted from doing so by the rigidlinkage between interest rates and exchange ratesand the primacy of the exchange rate stability overincome growth. If the exchange rate weakens, inter-est rates must rise to appreciate the exchange ratebefore any other consideration. If monetary policyis assigned to both internal growth and external sta-

bility, then growth would require expansionarymonetary policy while external stability wouldrequire contractionary monetary policy. Balance ofpayments and exchange rate concerns generally pre-dominate over economic growth considerations inthese circumstances, so the goal of growth gets sac-rificed.

In a fixed exchange rate regime for the long-run,market pressures that generate nominal exchange rateequilibrium points above or below the fixed nomi-nal rate must be responded to by the central bank. Ifthe expectations of currency holders shift toward ade facto depreciated level for the exchange rate, thecentral bank would have to sell dollars to take localcurrency out of circulation to restore the market-determined nominal rate to the fixed nominal rate.This reduction in the money supply causes interestrates to rise leading to declines in output or incomefrom what they would have been under a floatingrate regime. The force field affecting macropolicyunder a fixed rate regime dampens the rate of eco-nomic growth and restricts the capability of monetarypolicy to stimulate growth. This is the cost in realeconomy terms for the financial stability achievedboth in the exchange rate and in the price level.Monetary policy autonomy is lost and the priorityof real economy objectives are made secondary tofinancial objectives because of the deflationary pres-sure on monetary policy of a fixed exchange rateregime.

However, it is also the case (though it will notbe demonstrated here) that only fiscal policy is ef-fective in stimulating growth in output and incomes(GDP) under fixed exchange rate regimes eventhough fiscal policy is not effective in flexible, mar-ket-determined exchange rate regimes. In principle,it should be possible to stimulate economic growthwith fiscal policy in a fixed rate regime. The now-familiar conundrum of too few instruments for toomany goals reappears. Since exchange rate policy islocked to price stability as an exchange rate anchorin a fixed rate regime and monetary policy autonomyis lost as a consequence, fiscal policy is the onlymacropolicy instrument left. Policy makers areforced to choose between assigning fiscal policy tothe internal goal of growth or to the goal of externalbalance (configuration # in chart 1). External stabil-ity in the short-run, both exchange rate stability andbalance-of-payments financing, normally pre-emptsthe long-run growth trajectory of the economy. Thisforces policy makers to contract fiscal policy to


achieve external balance rather than stimulate theeconomy to achieve growth in incomes and jobs.

Therefore, under both flexible and fixed rateregimes there are forces pushing macropolicy towarda deflationary impact on the economy for the sakeof financial stability rather than toward stimulatingeconomic growth for the sake of social stability. Inthe current circumstances and after recent experi-ences in the wake of the Asian financial crisis in the1990s, this is an unacceptable set of policy choicesfor most governments in developing countries, es-pecially for those that are democratically elected.This leads to a search for enhancing the space formacropolicy choice, especially for developing coun-tries with enormous numbers of people in povertyleft behind by insufficient and unsustained rates ofeconomic growth.

IV. Selective pragmatism

Markets are extraordinarily powerful mecha-nisms. No set of people knows this better than thosewho are or have been ministers of finance or centralbank presidents. If market forces are pushing majormacropolicy variables like the real exchange rate orthe real interest rate away from their nominal valuesand governments are trying to force equilibrium ormaintain divergence against the grain of the market,there is a limit to how long the government policycan prevail over markets. This is not an ideologicalstatement based on value preferences. It is a fact ofeconomic life that determines the range within whichreasonable, effective economic policy can be forged.Wishful thinking does not work. Only policies thatare within a set of boundaries that are realistic interms of market pressures are feasible policies. Thesearch for larger policy space for macropolicychoices has to be driven by rational pragmatismbased on realities rather than by idealism based onhope or ideology based on hidden political agendas.

A useful framework for thinking about policyoptions in this context is the trilemma. The trilemmaposits three desirable policy positions known as �theimpossible trinity� and the trade-offs between them.All countries, undoubtedly, wish to have a stableexchange rate, an open capital account, and autono-mous monetary policy. The trilemma helps makeclear that these three desiderata are actually trade-offs. Policy makers are forced to be on one of the

three sides of the triangle on a line embracing onlytwo of the three desiderata and foregoing the third(see chart 2). From the above analysis of fixed andflexible exchange rate regimes, it is clear that a cur-rency board can achieve a stable exchange rate withan open capital account but only at the expense ofan autonomous monetary policy. A floating rate re-gime can restore monetary policy autonomy with anopen capital account at the cost of some potentialexchange rate volatility. Similarly, implementingcapital controls can also restore monetary policyautonomy with exchange rate stability but at the costof free capital movements.

Whereas the trilemma shows that there is a needto choose which of the two desiderata are preferred, itis also the case that there is not a requirement to go towhat John Williamson has called �the corner solutions�(Williamson, 2000). It is possible to engage in selec-tive capital controls and a managed-interventionexchange rate regime which reclaims some monetarypolicy autonomy. These moves away from the cor-ners create more policy space within the originaltriangle of the trilemma (above) bounded by the moreextreme positions of fixed exchange rate, entirely opencapital account and fully autonomous monetary policy.2

This policy space creates two opportunities toenhance the range of macropolicy choice. One is toprovide opportunities for different mixes of policyinstruments in which the degrees of deployment ofeach policy tool can be calibrated to fit specific cir-cumstances. This is a significant difference from apolicy setting of either-or choices and corner solu-tions. Second, this enhanced policy space allowscountries to have four macropolicy instruments �fiscal, monetary, and exchange rate policies and par-tial capital controls � which permit the country topursue four policy goals: price stability, current andcapital account balance, and growth.

This innovation in policy stances is feasiblebecause moving toward the pragmatic middle3 in-stead of the extreme �corners� enlarges the numberof goals it is feasible to pursue due to enlarging thenumber of instruments that are available. Capitalcontrols and exchange rates cease to be �corner so-lutions� and can be �assigned� to specific goals,increasing the number of policy tools to match thenumber of policy goals.

Therefore, there are three major steps thatachieve enhanced policy space: the idea of fiscal


policy-based stabilization replacing exchange rateanchors; intermediate exchange rate regimes replac-ing the extremes of fixed versus floats; and selectivecapital controls replacing the false dichotomy offully open versus fully controlled capital accounts.

V. Fiscal policy-based stabilization

One of the reasons why countries have beenbacked into the corners of the trilemma is that theythemselves have failed to sufficiently discipline fis-cal policy, and to a lesser extent monetary policy, tosustain a stable economy and exchange rate. Theclassic case is Argentina which for decades couldnot as a nation maintain fiscal discipline whichspilled over into rapid inflation, balance-of-paymentscrises, external debt excesses, and political upheav-als. Finally, in the early 1990s, an innovative financeminister, Domingo Cavallo, turned the economy onits head by getting Congress to pass a Constitutionalamendment establishing a currency board of one Ar-gentine peso equal to one dollar (Corrales, 1997; and

Dominguez, 1997). This policy move effectively�assigned� the exchange rate to internal price sta-bility and used it as an anchor for domestic prices tohalt the momentum of hyperinflation. Monetary policyautonomy was sacrificed to support the currencyboard. Open capital accounts were maintained toprovide an avenue for financing current account defi-cits. Only fiscal policy remained. In this context,fiscal policy should have been assigned to externalbalance since exchange rate policy had in effect takenover from fiscal policy to achieve price stability.

But since fiscal policy �works� in fixed exchangerate regimes, under the currency board fiscal policyin Argentina was de facto available for double-duty asan instrument for stimulating economic growth.Given Argentina�s anomalous relationship betweenthe central government�s sole responsibility for rev-enue raising and expenditure autonomy of stategovernments, fiscal discipline was impossible tomaintain. Continuous fiscal deficits within a fixedexchange rate regime eventually acts like steam in apressure cooker. The economic meltdown in Argen-tina following the failure of the currency board was

Chart 2

TRILEMMA

Note: Extreme policy stances in the corners, such as completely open capital account, fully autonomous monetary policy orfixed exchange rate regimes force policy choices on the lines connecting the corners of the triangle, meaning that oneof the three options is foregone. Pragmatic policy stances of selective capital controls, some monetary policy autonomyand managed exchange rate regimes create a policy space within the triangle in which different policy combinations canbe developed.

Currency board

Stable exchange rate

Capital controls

Open capital accountFloating exchange rate

Autonomous monetary policy


one of the most devastating economic crises of mod-ern times. One of the conclusions from this experiencehas to be that fiscal discipline is a sine qua non foreconomic policy regardless of whether the exchangerate regime is fixed or flexible or a mix (Mussa,2002: 6). This is an old lesson, articulated long agoin the economic literature, but hard to implement inthe world of policy practice.

For the future, it seems essential to insist thatexchange rate stability and economic stabilizationmore generally depend upon fiscal policy disciplineregardless of the type of exchange rate regime. Itwould seem to be more effective to have fiscal-basedstabilization programmes than to use exchange ratesas anchors for achieving price stability. In the rearview mirror, exchange rate-based stabilization pro-grammes look like furtive attempts to escape thefiscal policy straight jacket which, it now mustbe realized, has to be worn whether it feels good ornot and whether the exchange rate is fixed or flex-ible.

With this notion of fiscal policy-based stabili-zation as a guide, fiscal policy can be assigned toprice stability with the important implication thatfiscal discipline will now be the primary foundationfor exchange rate stability. This occurs both directlythrough controlling the price level and through con-trolling the expected exchange rate. One could eventhink of this assignment as fiscal policy-based ex-change rate policy.4 The additional instrument ofcapital controls is assigned to the capital account.The exchange rate is assigned to the current accountinstead of to price stability as under a currency board.With this configuration, monetary policy is avail-able to be used as an instrument for economic growthand employment creation instead of being foregoneas a macropolicy tool.

This four-by-four policy (4x4) assignmentmatrix in chart 3 is made possible by using fiscalpolicy for internal stabilization instead of the ex-change rate, by exploiting the fact that fiscal disci-pline has important spillover effects on exchange ratestability, and by avoiding the extremes of entirelyopen capital accounts or fixed exchange rates. Se-lective capital controls can be assigned to the capi-tal account whereas fully open capital accountsdeprive policy makers from using capital controlsas a tool of macropolicy. The number of policy toolsis equal to the number of real and financial goals sothat economic growth can be prioritized (chart 3).

There are three ways, then, that these movesprovide more policy space for monetary policy, spe-cifically. First, fiscal policy-based stabilization haspositive spillover effects on the exchange rate byproviding a credible foundation for its stability. Thereis less need for high interest rates to strengthen anexchange rate already perceived to be strong byvirtue of fiscal policy discipline under girding it. Sec-ond, capital controls assigned to the capital accountallow the domestic interest rate to differ somewhatfrom the world interest rate without such drasticconsequences as under the assumption of perfectcapital mobility and open capital accounts. Third,selective exchange rate intervention loosens the au-tomatic necessity of foreign exchange sales orpurchases required under fixed exchange rates withdirect consequences for the interest rate. Intermedi-ate exchange rate regimes with fiscal policy-basedstabilization can rely on a stronger exchange rateless affected by expansionary monetary policy thanwould have been the case with both monetary andfiscal policy assigned to growth, which could weakenthe credibility of the exchange rate over time threat-ening its stability.

Chart 3

ASSIGNMENT OF POLICY TOOLS TO POLICYGOALS UNDER INTERMEDIATE EXCHANGE

RATE REGIMES (X)



Fiscal policy X+

Exchange rate + X

Capital controls X

Monetary policy X

Note: In intermediate exchange rate regimes (soft pegs andmanaged floating), the interest rate is delinked fromthe exchange rate, freeing up monetary policy forassignment to economic growth. Selective capitalcontrols become the fourth policy instrument and areassigned to the capital account. Fiscal policy-basedstabilization becomes the foundation for internalprice and the exchange rate (+) stability, which givesmore room for monetary policy to stimulate growth.


This set of goals and assignments contrasts withthe deflationary bias of floating rate regimes and withthe constraints imposed by fixed rate regimes whichleave fiscal policy bearing all the burden for inter-nal and external balance. This combination ofselective pragmatism in exchange rate and capitalaccount management creates enough policy instru-ments for the number of policy objectives andprovides the enhanced policy space essential forprioritizing economic growth in national economicpolicy. Fiscal policy-based stabilization frees up theinterest rate from its rigid link to the exchange rateby directly and indirectly strengthening the real ex-change rate. This configuration has the advantagethat monetary policy is an agile instrument for pro-moting economic growth due to the fact that it canbe controlled more directly, immediately and flex-ibly than fiscal policy.

A problem with policy assignment scenarios isthat spillover effects do, of course, occur. The ef-fects of the use of the policy variable do not staycontained within the cell of the matrix the assign-ment designates, to be sure. The effects of fiscaldiscipline does dampen growth which monetarypolicy is trying to stimulate; monetary expansionlowering interest rates does weaken the exchangerate which tight fiscal policy is trying to strengthen.The assignment is not univalent, only affecting thedesired outcome variable. This is a complication inall economic policy. The challenge is to manage withthe policy space available the tensions and trade-offs embedded in each specific context.

VI. The exchange rate debate andpolicy space

The issue of policy space is tightly linked tothe debate surrounding exchange rate regimes onwhich there is a variety of views. In back-to-backarticles from the American Economic Associationannual meeting in 2000, there are two diametricallyopposite prognostications. Chang and Velasco write:�The question for most emerging market economiesis no longer �To float or not to float?� but �How toFloat?� � (Chang and Velasco, 2000: 71). By con-trast Reinhart writes: �If �fear of floating� continuesto be the serious policy issue it has been in the past,and if ... lack of credibility remains a serious obsta-cle, then the only way to avoid the �floating andcredibility problems� simultaneously may be full

dollarization. A corner solution indeed!� (Reinhart,2000: 70). A year later, Dornbusch wrote: �Five argu-ments make up the case against currency-boardarrangement ... On the surface each argument is per-suasive; on closer scrutiny none really is� (Dornbusch,2001: 238�239). Fischer concluded after a survey oftrends in exchange rate regimes in the 1990s, �thereis clearly a trend ... in the direction of hard peggedexchange rate regimes� (Fischer, 2001: 18).

These representative articles give a flavour ofwhat Fischer called the �bipolar view� that the realchoices are between floating and fixed and that thereis what John Williamson has called �the missingmiddle�. If these views are correct, then the possi-bility of moving toward selective intervention incurrency markets through �soft� pegged exchangerates or dirty floats with off-setting monetary actionswould jeopardize the argument that policy space canbe realistically enhanced by implementing alterna-tive intermediate exchange rate regimes between thecorners.

From the point of view of the line of reasoningpresented here, a managed float exchange rate re-gime where there is central bank intervention inmoney markets for exchange rate management pur-poses constitutes a move away from the boundarylines of the trilemma and a factor in enlarging thepolicy space within the original triangle. Ninety onecountries or just under 50 per cent of the 185 countriessurveyed by Fischer (2001) at of the end of 1999 hadintermediate exchange rate regimes (managed floatsor soft pegs) while 19 per cent had hard pegs, 5 percent have joined currency unions (the EU) and 27 percent had independent float regimes (see table 1).5

As a consequence, there were nearly as manycountries at the end of 1999 that had intermediateexchange rate regimes which would potentially en-hance policy alternatives through enlarged macro-policy space as there were countries with fixed orfloating rate regimes with reduced policy discretion.As Frankel has put it recently, a more nuanced in-terpretation of current policy dilemmas would be torealize that the trilemma does not have to requirethat �one give up both complete stability and com-plete independence� and that it is possible to have�half-stability and half-independence in monetarypolicy� (Frankel, 2003: 17, italics added). There isroom for policy choice when the purity of the cornersis abandoned and pragmatic policy decisions substi-tute for options pushed by market fundamentalism.


VII.Selective use of capital controls

Another example of this pragmatic approach isin the arena of capital controls. Given the number ofdifferent types of capital transactions, there is noparticular reason beyond ideological ones why itwould necessarily behoove a country to adopt thesame policy for all types of capital transactions.Rather, there are alternatives for differential treat-ment for capital inflows as opposed to capitaloutflows, for short-term versus long-term capital, forportfolio flows vis-à-vis direct foreign investment,etc. The approach of selective intervention appliedto capital controls achieves a similar result as that ofselective intervention in foreign exchange marketsin moving policy decisions out of the corners of ex-treme measures and off the boundary lines of thetrilemma triangle.

The use of capital controls by national gov-ernments is widespread. Until 1997 the IMF had onlyone line for capital controls in its Annual Report on

Exchange Arrangements and Exchange Restrictions(AREAER). In 1997 a new system was developedwhich contained a dozen categories, increasing to13 in 1998.6 From 1997 to 2003, the IMF publishedsummary tables showing the use by national govern-ments of capital controls in each of these categoriesfor all members of the IMF (see summary in table 2).

The patterns are clear.7 First, a substantialnumber of countries utilize a variety of capital con-trols. In 1996 over 100 countries registered themselvesas using capital controls in seven of the 13 catego-ries. Hence, capital controls were in wide use beforethe Asia crisis. Second, there was a significantincrease in capital controls from 1996 to 1997, prin-cipally in two categories: financial credits andprovisions specific to commercial banks and othercredit institutions. This reflects the immediate re-sponse of countries during the Asia crisis. Lookingat the 1996�2002 period as a whole after the Asiacrisis, there were two types of trends. First, by 2002there was an increase in the use of capital controlsin additional categories, especially controls on per-sonal capital movements and institutional investors.Second, there was virtually no increase or a slightdecline in the use of capital controls in eight of the13 categories between 1996 and 2002. These twotrends together show the selective targeted natureof the use of capital controls in contrast to an across-the-board approach in the wake of the Asia crisis.

Based on these patterns, it can be seen that thereis already widespread use of capital controls by na-tional governments. By 2002, over 90 countries usedcapital controls in each of 11 of the 13 categories.Whereas there was a significant increase in use in1997 during the Asia crisis, it was not an avalanche.There was not a sea-change in the use of capital con-trols in 1997�1998 or beyond, for that matter. Butthere has been a steady increase in the use of sixtypes of capital controls, including real estate andguarantees, from 1996 through 2002. This suggestgreater eclecticism and pragmatism in economicpolicy-making since the Asia crisis.

The other important trend is that whatever ten-dency there was toward capital account liberalizationbefore the Asia crisis, it seems to have come to ahalt after it. Increased selective management of capi-tal controls since 1996 seems to be an economicpolicy reality, just as the increase in intermediateexchange rate regimes in the 1990s has become evi-dent as well. These two moves away from the

Table 1

TYPE OF EXCHANGE RATE REGIMEAPPLIED IN DIFFERENT CATEGORIES

OF COUNTRIES

Hard Inter-peg mediate Floating Total

Developed countries 11 3 8 22

Emerging marketeconomies 3 17 13 33

All other countries 31 71 28 130

Total 45 91 49 185

Source: Fischer (2001), figures 1, 2 and 3; and tables 1, 2 and 3.Note: There were 28 countries with managed float regimes

at the end of 1999, which together with 63 countrieswith �intermediate� exchange rate regimes (�soft�pegs of some sort) constitute a group of 91 countriesout of a total of 185 countries. Within the frameworkbeing developed in this paper, managed float regimesare �intermediate� regimes rather than in the samecategory as �independent float� regimes, as inFischer (2001).


extremes relieve the need to forego policy instrumentsand options for the sake of corner solutions and helpcreate an expanded policy space in which policymakers can prioritize economic growth and combinepolicies to achieve multiple financial and realeconomy policy objectives simultaneously.

The selective use of capital controls in largeemerging market economies is beneficial as a meansof dampening exchange rate volatility but at the sametime is hard to impose in a world of highly inte-

grated capital markets. Selective use of capital con-trols may still be feasible in these large middleincome countries which now constitute importantplayers in the global economy providing that mon-etary and fiscal policy discipline are sufficient topersuade markets that they are on a sustainable policypath. Selective capital controls and exchange rateintervention are even more feasible in smaller mid-dle and lower middle income countries where thereis less pressure from global financial markets thanis the case in large emerging market economies.

Table 2

USE OF CAPITAL CONTROLS: 1996�2002

(Number of provisions)

Capital transactions 1996 1997 1998 1999 2000 2001 2002

Controls on:

Capital market securities 128 127 133 125 128 131 128Money market instruments 112 111 115 110 111 110 107Collective investment securities 107 102 103 103 102 101 99Derivatives and other instruments 78 82 87 83 84 83 83Commercial credits 103 110 105 108 109 107 104Financial credits 76 114 112 113 114 113 112Guarantees, sureties and financial backup facilities 82 88 88 93 97 96 92Direct investment 144 143 149 147 146 147 149Liquidation of direct investment 54 54 52 54 57 59 57Real estate transactions 119 128 134 136 138 135 137Personal capital movements n.a. 64 82 90 93 91 97

Provisions specific to:

Commercial banks and other credit institutions 131 152 155 158 157 157 160Institutional investors 60 68 82 83 84 86 91

Source: International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions, annual issues,1997 through 2003. These reports are for the IMF financial year which ends on 30 April of the year of the Report. Thisis important since in 1997 countries reported before the Asia financial crisis that hit in mid-year. Individual countriesreport at different points in the year, but basically the Report reflects conditions in the previous calendar year.


VIII. From populism to orthodoxy toheterodox policy packages

If it is the case, as is argued here, that conven-tional economic wisdom tends to favour financialstability before if not indeed over economic growthand that there is a deflationary bias in conventionaleconomic policy thinking, then it is also the casethat efforts to reverse this prioritization and introducea pro-poor growth bias in macropolicy managementhave sometimes erred in the opposite direction. Infact, there has been a variety of experiments in re-cent years some of which have come to be called�the macroeconomics of populism� (Dornbusch andEdwards, eds., 1991). Others have had more ortho-dox stabilization programmes while still others haveintroduced novel measures of a heterodox nature. Abrief review of these experiences can provide thebasis for adding policy instruments to the 4x4 policymatrix as another means of enhancing macroeconomicpolicy space (Agenor and Montiel, 1996: 265�297).

The two experiments in macroeconomic populismoften cited are the Allende regime in Chile from 1971to 1973 and the Garcia Government in Peru from1986 to 1990. In both cases, there were direct inter-ventions to increase wages on the one hand andcontrol prices on the other with the hope that the realwage for workers would increase squeezing profitrates but increasing total profits. Interestingly, bothgovernments moved off managed exchange rateregimes to fixed exchange rates as a means of con-trolling inflation but also to keep external debtpayments a lower share of GDP. With budget defi-cits increasing substantially in both countries,inflation exploded undermining the exchange rate,ultimately causing a haemorrhage in capital outflowsdepleting foreign exchange reserves.

In Chile the fiscal deficit went from 3 per centof GDP in 1970 to 25 per cent in 1973, while in Peruthe public sector deficit went from 3 per cent in 1985to 7.5 per cent in 1988. GDP growth surged in theearly years of both governments to 9 per cent in Chilein 1971 and to 8.5 to 9 per cent in Peru in 1986�1987only to plummet in both countries to -5.6 per cent in1973 in Chile and to -8 and -11 per cent in Peru in1988 and 1989. Inflation in both countries soaredfrom 35 per cent per year in 1970�1971 in Chile toover 600 per cent in 1973 and from 63 per cent inPeru in 1986 to over 2700 per cent in 1989 (Agenorand Montiel, 1996: tables 8.2 and 8.3; and text pages

267�270). Both efforts ended in collapse withAllende being overthrown by Pinochet in 1973 andGarcia loosing in an election to Fujimori in 1989.The policy problem in these Governments was oneof essentially sacrificing the goals of internal pricestability and external balance for the goal of growthonly to have the financial disequilibrium generatedby this policy mix explode destroying the short-termreal economy gains. The forcing hand of externalimbalance manifested itself in these two populistexperiments undermining the internal agenda and thegovernment itself.

It appears to be that in cases of macroeconomicpopulism �in the end, foreign exchange constraintsand extreme inflation forced a program of violentreal wage cuts that ended, in many instances, inmassive political instability, coups, and violence�(Dornbusch and Edwards, eds., 1991: 8). Neverthe-less, it also appears to be the case that orthodoxstabilization programmes involving major macro-policy adjustments end up restoring price stabilityand the balance of payments at the expense of GDPgrowth, real wage levels and employment. The casescited in Agenor and Montiel (1996) are Chile underPinochet from 1974 to 1977 and Bolivian reformsin 1985. Fiscal adjustment was the centrepiece ofthese two reform efforts. In Chile the fiscal deficitdeclined from 25 per cent of GDP in 1973 to 2.6 percent in 1975. The exchange rate was assigned to thecurrent account rather than to price stability and wasdevalued at a rate greater than the inflation rate whichimproved the competitiveness of exports consider-ably. But success on the current account was notmatched on the inflation front and furthermore GDPshrank by 14 per cent and unemployment mush-roomed to 17 per cent in 1975. In Bolivia, a similarpattern emerged with draconian shifts from a fiscaldeficit of 30 per cent of GDP in 1984 to a surplus of3 per cent in 1986 with greater success than Chile inreducing inflation but with decidedly negative ratesof GDP growth (Agenor and Montiel, 1996: tables8.4 and 8.5; and text pages 270�275).

After a set of not overwhelmingly successfulexchange rate-based stabilization programmes inChile, Uruguay and Argentina initiated in 1978, itwas realized in the 1980s that in this sequence ofexperiences in Latin America none were able toachieve financial and real economy objectives si-multaneously. As a result, a number of still moreinnovative policy packages were undertaken in themid-1980s in Argentina, Brazil, Israel and Mexico


(Agenor and Montiel, 1996: 282�297). These het-erodox approaches yielded up several additionalinstruments of economic policy which help generatea greater amount of flexibility and combinationsenhancing macropolicy choice.

For example, debt reschedulings in the 1980sbecame an additional instrument for achieving capi-tal account balance, while trade liberalization becamea tool for achieving improvements in the trade orcurrent account balance. Privatization of public en-terprises became a way of temporarily improvingthe public sector deficit and capital inflows at thesame time. The problem was that privatization wasnot a continuous source of additional finance but atemporary one. Wage and price controls (�pactos�)were increasingly applied as a way of trying to in-crease real wages while containing inflation. Newcurrencies were created as a way of gaining a freshstart and innovative exchange rate managementmodalities were experimented with as ways of steer-ing between fixed and flexible exchange rates. Thenew policy instruments � wage and price controls,trade liberalization and debt rescheduling � can beassigned within the traditional 3x3 matrix to the goalsof price stability, the current account and the capitalaccount, respectively (chart 4).

This new assignment frees up monetary andfiscal policy to have greater room to promote growth,employment and poverty reduction, while maintain-ing sufficient discipline to further contribute tocontaining inflation and to exchange rate stability,against the background of a stable financial contextstrengthened by these new measures. See 4x4 as-signment matrix above. The prioritization of realeconomy objectives is more feasible in contexts inwhich policy instruments are being added to the mixthan in ones in which they are being foregone. Andthe possibilities for coming up with a variety of pos-sible policy packages to promote real economy goalsincrease as the number of policy tools increases. Asa consequence, these heterodox policy experimentsand experiences have made important contributionsto enhancing the degree to which monetary and fis-cal policy can be assigned to economic growth whileincreasing policy flexibility and choice. Anothersource of new policy perspectives has been the dy-namic growth of the East Asian economies since the1970s and their rapid recovery from the Asian fi-nancial crisis in the late 1990s.

Chart 4

ILLUSTRATIVE ASSIGNMENT OF �NEW�POLICY TOOLS TO POLICY GOALS AS AMEANS OF PRIORITIZING ECONOMIC

GROWTH AS A GOAL OFMACROPOLICY



Wage-pricecontrols X

Tradeliberalization X

Debtrescheduling X

Monetary andfiscal policy X

Note: The choice of the exchange rate regime in thisscenario is delinked from the need for the exchangerate to be assigned to price stability as an exchangerate anchor, since it is assumed that monetary andfiscal policy discipline are sufficient to containdomestic inflation and undergird a stable exchangerate, regardless of exchange rate regime choice. Thisis a sine qua non of macropolicy. This contextpermits managed-float or soft-pegged type�intermediate� regimes to work to create moremacropolicy space for a greater number of fiscal andmonetary policy options to be potentially applied tothe goal of economic growth. Selective use of capitalcontrols, while helping improve the capital account,in this scenario also enhances the macropolicy spacefor the application of monetary and fiscal policy togrowth objectives.


IX. The East Asian experience: strategicframeworks for macropolicy

Today, Latin America and East Asia again seemto be juxtaposed in the minds of many as examplesof failure and success, similar to the great debateover the reasons for the success of the �East AsianMiracles� in the 1980s and 1990s. Now, LatinAmerica is looking back on a period of twenty yearsof economic policy reform and re-democratizationand finding the economic and social benefits of thesereforms to be wanting. Economic growth has beenslower than anticipated; unemployment continues tobe high; and poverty reduction has not improved atthe rate hoped for. Several studies have concluded thatthe reforms associated with the market liberalizingagenda of the Washington Consensus have not led tosufficient economic growth nor to accelerated socialimprovement (Ocampo, 2003; and Correa, 2000).There have been several efforts by Latin Americansand others to rethink development strategies for LatinAmerica to break the stall in progress perceived toplague the region to this point (Kuczynski andWilliamson, eds., 2003; and Bradford Jr., 2004).

By contrast, East Asia seems to have reboundedfrom the Asia financial crisis in the late 1990s andbe regaining the growth momentum that had distin-guished its performance over the last three decades.In this context, recalling how Latin America and EastAsia were presented as studies in contrast in the1980s and early 1990s, it seems appropriate to in-quire regarding the lessons that might be drawn fromthe dynamic growth experience of East Asia thatmight inform an effort to reformulate strategic think-ing in the rest of the developing world.

The debate regarding the East Asian successstories was one in which two stylized dichotomieswere pitched against each other. Latin America wasseen as undertaking inward-looking, price distorting,interventionist, policies which made their economiesinefficient and slow growing. East Asia was seen asimplementing outward-oriented, liberalizing, market-driven, export-led growth strategies. These contrast-ing features were meant to explain the differencesbetween the two regions in terms of failure and suc-cess.

Given this way the debate was structured, theconventional wisdom tended to see macropoliciesas subservient to the exigencies of market liberali-zation, especially trade liberalization. This meant that

the role of macropolicy was to maintain tight mon-etary and fiscal discipline to keep inflation down toenhance the country�s competitiveness as it soughtto create an export-led growth path based on open-ness to the world economy, domestic prices equallingworld prices, and a real exchange rate that wouldnot be over-valued. These in essence constituted whatcame to be in 1989 the Washington Consensus. Theexport-led growth strategy, from the mainstreampoint of view, was based on the idea that growthwould be driven by external demand inducing ex-port growth in countries with open economies andsound macropolicies. Macropolicies had a second-ary role in this formulation aimed primarily atachieving price stability which in the context of atrade liberalization effort would presumably makethe economy competitive and lead to growth throughexports. Economic growth followed from financialstability rather than from a development strategy ora macropolicy that gave priority to growth. Rather,the priority was on economic integration with glo-bal markets which would force an alignment ofdomestic prices with world prices achieving com-petitiveness. The force field, from this perspective,was from outside inward.

Another way of seeing the same phenomenonviewed the process as working from inside outward.From this alternative perspective, deliberate devel-opment strategies were designed to accelerate growththrough high investment-GDP shares channelled bymarket forces and government guidance to high pro-ductivity sectors (Rodrik, 1997, 1999; Bradford Jr.and Chakwin, 1993; UNCTAD, 2002: 51�85; andUNCTAD, 2003: 57�89). These sectors had the po-tential to claim market share in world markets basedon a combination of actions, factors and policieswhich made those sectors highly competitive. Thenet result of this formulation was that the East Asiansuccess stories were seen as export-push rather thanas export-led regimes. The high performance of EastAsia was attributed to growth-led exports, with dy-namic economic growth generating supply-drivenexports, rather than to export-led growth which de-rived from openness to world demand (Bradford Jr.,1994). The clincher in terms of evidence in this de-bate seemed to be that East Asian export growth fortwenty years was several times the average growthrate in world demand for exports which gives morecredence to the export-push notion of insertion intoworld markets claiming market share over the open-ness to world markets, demand induced export-ledgrowth idea.


This rather extensive and extended debate overEast Asia does seem to leave the legacy of an activerole for policy in the process of accelerating eco-nomic growth. It seems clear now in retrospect thatthe stylized versions of East Asian success madechoices as between the market and the state, the pub-lic or the private sector, hands-on or hands offstrategies unnecessarily dichotomous alternatives.The East Asian success stories seemed to have hadvariety in their content. The Republic of Korea hada private sector driven by large corporations whereassmall and medium enterprises were dominant in Tai-wan Province of China. Hong Kong (China) wasclose to a laissez faire regime whereas Singaporewas characterized by a highly authoritarian anddirigiste hand of government in the economy. Therereally was no single economic model in East Asia.

Equally important the relationship between thepublic and the private sector appears have been cata-lytic, more in the nature of lose coordination andeven cooperation than coercive, directive or dichoto-mous. Public policies were meant to follow themarket rather than replace it, enhance competitive-ness rather than protect against it or subsidize it, andcreate an enabling environment in which privateenterprise could not only be efficient but also dynamic.These strategic characteristics of public-private sec-tor relations facilitated an exceptional performancein both economic growth and exports.

Macropolicy in East Asia was a part of the de-velopment strategies of the region which weresteadfastly dedicated to dynamic growth, rapid struc-tural change internally, and high export performance.Monetary and fiscal discipline were maintained;external debt levels were not large as a percentageof the fast-growing GDP; and exchange rates didnot become overvalued. Macropolicy was agile,highly responsive to shifts in the external context,rather than locked into a policy path. But the clearpriority was on growth; financial stability was sub-ordinate to the primacy of dynamism.

A key aspect seems to have been the connec-tion between macropolicy and structural policy inwhich the links between sectoral policies, trade andmacroeconomic growth contributed significantly toeconomic dynamism. Heckscher-Ohlin theory oftrade suggests that there is a ladder of comparativeadvantage in which countries find themselvesmoving from natural-resource based production(agriculture and mining) to labour intensive manu-

facturing, to capital intensive manufacturing to hu-man capital intensive production, and services totechnology intensive industries. This ladder repre-sents ascending rates of productivity growth ascountries move up the ladder. Shifts in the sectoralcomposition of output drive rates of structuralchange. Empirical evidence suggests that countrieswith high export-GDP shares have high rates of struc-tural change (Bradford Jr., 1994: table II, page 30and pages 19�20). As countries grow fast their work-ers become both better paid and better educatedwhich means that sectors requiring higher skilledlabour tend to grow as capital accumulates and even-tually replace sectors with lower skill requirements.These internal shifts in production patterns result incommensurate changes in the composition of trade.The interaction of growth, structural change andtrade is one of the principle dynamics that drive thehigh performance of the East Asian economies.

It seems fair to say in retrospect that the lead-ership of the East Asian economies were more con-cerned about the competitiveness of their economiesin the broadest sense than in the narrower issue ofthe appropriate level of their exchange rate. Onemight say they were more concerned about the realeffective exchange rate of their economies than thevalue (real or nominal) of their exchange rate. Thismeans that they were concerned about the institu-tional environment, the banking system, labour-management relations, the business culture andclimate, rule of law and commercial codes as com-ponents of competitiveness along with sound macro-economic policy conditions. The East Asian view ofdynamic economic growth was holistic and inte-grated not narrow and technical. Their economicpolicies were embedded in a broad strategic frame-work which was inclusive. Their view of competi-tiveness went beyond �getting prices right� andbeyond getting policies right to a broad sweep ofinstitutional, behavioural and regulatory norms. Thestrategic perspectives and choices were critical totheir success.

The East Asian experiences of highly dynamicgrowth provide examples of how economic policycan be integrated into a larger strategic frameworkwhich includes structural policies, institutional di-mensions and a catalytic role for government inengaging, involving and facilitating private sectorparticipation in the growth strategy. In the East Asiancases both the public and the private sector arecomplementary participants in enhancing national


competitiveness, accelerating economic growth andinsertion into the world economy. Macroeconomicpolicy management was exemplary in East Asia butmacropolicy management by itself does not explainthe high economic performance. The effectivenessof macropolicy in East Asia resulted from its beinga part of a larger strategic framework that mar-shalled other dimensions and assets to achieveexceptional growth, generating higher yields fromsound macropolicies. The East Asian experienceprovides useful insights into how to take full advan-tage of enhanced macroeconomic policy choice togenerate major impacts on economic growth, em-ployment and poverty reduction.

X. Conclusions: the logic of enhancedmacropolicy space and itsimplications

This paper has spelled out the logic for increas-ing policy space for the conduct of macroeconomicpolicy for the purpose of prioritizing real economygoals of growth, employment creation and povertyreduction. The logic has proceeded in several steps.First, there is the need to create more policy instru-ments so that a greater number of policy goals canbe addressed. Frequently, real economy goals getcrowded out by financial objectives in part becauseoften there are too few instruments for too manygoals. The heterodox policy experience of severaldeveloping countries has yielded additional arenasfor policy action as well as more policy tools whichhelp alleviate the crowding out problem.

Second, there is a need to avoid extreme all-or-nothing policy choices which have the effect ofreducing the number of policy instruments availableas well as the effect of assigning the remaining policyinstruments to the more urgent goals. Financial andexternal crises tend to trump in this situation. Herethe calibrated use of policy tools by degrees of com-mitment, deployment and assignment can createspace for mixes of policies. This enhanced policyspace yields a wider range for different combina-tions of policies which replace dichotomous choicesbetween extreme �corner solutions� such as openversus closed capital accounts, fixed versus flexibleexchange rate regimes, autonomous versus foregonemonetary policy discretion, as embodied in thetrilemma. Selective capital controls, intermediate

exchange rate regimes, and some monetary policyautonomy create the policy space within which avariety of policy combinations and mixes are possi-ble and a greater number of instruments are availablefor assignment to policy goals. Prioritization of realeconomy goals becomes both more feasible and morelikely with a broader range of policy alternatives.

Third, along with the selective use of capitalcontrols, fiscal policy-based stabilization instead ofexchange rate-based stabilization delinks the ex-change rate from the goal of internal financialstability to which it is yoked in a fixed rate regime.This delinkage enables the use of intermediate ex-change rate regimes (soft pegs and managed floats).The use of these regimes in �the missing middle�create policy space where different mixes are possi-ble generating a greater range of policy alternatives.With fiscal policy assigned to internal balance, theexchange rate can be assigned to the current accountand selective capital controls to the capital account.Under this configuration (see chart 3) monetarypolicy is loosened up from its rigid linkage to theexchange rate by fiscal discipline strengthening theexchange rate. With this combination of fiscal dis-cipline, some capital controls and an intermediateexchange rate regime, monetary policy can then beassigned to economic growth. The degree to whichmonetary policy can be assigned to growth is but-tressed by the degree to which the other macropolicytools are used to achieve internal and external balance.Monetary policy has the advantage of an instrumentfor growth that is able to be flexibly managed.

Fourth, prioritizing real economy goals is alsofacilitated by the design of a larger strategic frame-work for accelerated development which includesinstitutions, norms, behaviours and governance. Thelarger strategic framework mobilizes more assets andpower toward a dynamic growth trajectory whichcreates a more favourable context for macroeco-nomic policy. The growth, employment and povertyreduction outcomes from macropolicy are likely tobe larger when they are part of a wider effort tomarshal resources for accelerated development. Theexamples of the East Asian success stories providethe evidence for this conclusion.

These four steps in the logic for increasedmacroeconomic policy choice provide reasons tobelieve that there is indeed room for macropoliciesfor growth even in the face of considerable theoreti-cal and experiential evidence that there can be strong


deflationary biases in macropolicy-making. Thesefour innovations � new policy tools, selective prag-matism, fiscal policy-based stability, and strategicframework � reinforce each other in their capacityto create more policy space. To the extent that ef-forts are made on all four fronts simultaneously thegreater the flexibility and choice open to publics andpolicy makers in forging macropolicies appropriateto national contexts and current circumstances. Witha greater range of policy choice, economic policywould be able to contribute to the strengthening ofdemocratic process by engaging public institutionsand policy makers in open debate on alternativepolicy paths rather than isolating economic policy-making from public discussion due to the sense oflack of options.

Furthermore, enhanced policy space and alter-natives would be expected to enrich and enliven theinternational debate about the policy prescriptions,conditionality and development strategies of the in-ternational financial institutions as they seek tosupport development. The broader array of policyalternatives might be expected to bring more diverseperspectives from different country experiences tothe international discussion of policies of the inter-national institutions. There is more reason to havestronger mechanisms for global economic govern-ance and better representation from diverse countriesif there are fresh viewpoints and a wider range ofviews on effective combinations of policies. There-fore, the extent to which there can be greater degreesof choice in macropolicy-making is a key foundationalidea for creating a more representative and a moremeaningful system of global economic governance.

Nonetheless, it should be emphasized that thefeasible enhancement of macropolicy choicestrengthens national policy as the primary nexus fordecisions on national priorities and on the trade-offbetween economic growth and stability. Against thebackground of the pattern of global imbalancesrooted in domestic macropolicy imbalances overthe last thirty years, national governments have astrengthened hand as the principal mediator betweenthe global economy and national economies withincreased policy space. The supposed erosion ofnational autonomy due to globalization encounterscountervailing forces as countries are able to suc-

cessfully design pro-growth policy paths due to en-hanced macroeconomic policy choice. Nationaldecision-making is still the locus of governance ineconomic policy, even in an era of globalization. Thenation-state as the nexus point for macropolicychoice is another foundational idea of global eco-nomic governance.8

Notes

1 The equalization of returns in all markets in an integratedworld economy composed of open economies followsthe principle of interest parity which with capital mobil-ity requires that the combination of interest rate differ-entials between two markets and the difference betweentheir expected and actual nominal exchange rate mustbe equal. This means in effect that interest rate shifts inone market require an off-setting exchange rate adjust-ment, and conversely, an exchange rate shift originatingin one market requires an offsetting monetary policy (in-terest rate) shift in the other market. Otherwise, differ-ential returns between the two markets will lead to dis-proportionate flows out of one toward the other.

2 A similar argument is made in Frankel (2003, especiallypages 17�19). I am indebted to Susan Collins for thisreference.

3 The emphasis in this section on �rational pragmatism�and �the pragmatic middle� is in the same spirit asBryant�s superb treatment of cross-border finance in hissection on �A Middle Way: Steadfast Eclecticism� inchapter 12, pages 386�389, and elsewhere in Bryant(2003).

4 For an articulation of fiscal-based exchange ratestabilization, see Bradford Jr. (1999: 54�56). See alsoUNCTAD (2003, especially pages 137�138).

5 From Fischer (2001: figures 1, 2 and 3; and tables 1, 2and 3), there are 28 countries with managed float re-gimes at the end of 1999 which together with 63 coun-tries with �intermediate� exchange rate regimes (�soft�pegs of some sort) constitute a group of 91 countries outof a total of 186 countries. Within the framework beingdeveloped here, managed float regimes are �intermedi-ate� regimes rather than in the same category with �in-dependent float� regimes, as in Fischer (2001).

6 See especially section II, �Measures of Capital AccountRestrictions�, Edison et al. (2002: 4�19).

7 International Monetary Fund (IMF), Annual Report onExchange Arrangements and Exchange Restrictions(AREAER), annual issues 1997 through 2003. See �Sum-mary Features� tables in each volume, and also the pref-ace and introduction to the 1997 AREAR establishingthe new tabular format.

8 Bryant (2003: 390�398) makes very similar points in hischapter on �The Evolution of International FinancialGovernance�.


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