Fiscal and Monetary Policies in Developing Countries

State, Citizenship and Transformation

Rashed Al Mahmud Titumir

• Publisher: Routledge
• Year: 2021
• ISBN:
  9781000511307
• Edition: 1
• Topic: Economía
• Subtopic: Macroeconomía

The COVID-19 crisis has fractured the pre-existing structural rigidities and institutional fragilities in the economies of developing countries more than ever, necessitating a rethinking of fiscal and monetary policies, the main vehicles for relief, recovery and reconstruction.

This book examines the barriers to transformation in developing countries in the wake of the pandemic and analyses the paths to recovery based on an economic policymaking agenda. It juxtaposes fiscal and monetary policies and state-building from pre- and post-colonial periods to the present-day context. It employs an interdisciplinary approach and ventures beyond the well-rehearsed tendency to explain the state of developing countries by considering the experiences of advanced economies. The book utilises data on three levels: the aggregate level using world data, the single-country context with case studies and a cross-country assessment for comparative analysis. Further, the book critically assesses the relevance of different schools of thought and provides nuanced, thought-provoking theoretical apparatuses applicable to developing countries, as well as allowing the reader to undertake a country-specific analysis through the detailed historical country case studies undertaken in each chapter. Each chapter has a detailed and separate theoretical and empirical section for the ease of understanding of the key propositions in the book.

The book will find an audience among scholars and researchers alike, who wish to gain a deeper understanding of the formulation of fiscal and monetary policies, specifically in developing countries. For policymakers and policy advocates, the book will serve as the groundwork for monetary and fiscal policies in the context of developing countries, providing more relevant instruments for transformational pathways.

1 State-building and economic policymaking

DOI: 10.4324/9781003201847-1

Introduction

The book deals with the role of state in economic policymaking, particularly in developing countries. To understand the mechanisms and rationale behind policymaking, this book delves into a historical analysis of state formation and subsequent policymaking in developing nations. Economic policymaking, in the form of monetary and fiscal policy, is an indispensable part of the state organ. The effect of these policies is not just limited to traditional activities that shape an economy. The outcome of economic policies has influenced public choice in electing governments and political leaders as well.

The foundation of economics is still based upon the interaction between the agents of “production, distribution and consumption” as per the words of Jean Baptiste Say (1836), though economics has gone through various phases over the years as new ideas have been brought in to overcome any challenges. The basic idea of economics can be understood as the circular flow between agents, i.e., households and firms. As a concept, circular flow is not new; rather, it has been around for more than 200 years. The foundation of the concept was laid by John Law, and later works by Richard Cantillon and Francois Quesnay established the model in mainstream economics. John Law first devised the model based on an island economy. Paper money was circulated among three agents in the economy: landlords, manufacturing workers and farmers. Landlords used paper money to buy commodities from manufacturing workers (Murphy, 2009). The workers then used that money for buying food from the farmers, and later the farmers paid the landlords rent in money earned from selling the food. Later on, Richard Cantillon in his book Essay on the Nature of Trade in General, published in 1755, developed the model based on both the agrarian and the urban economy. Economic agents in his model were property owners, farmers, entrepreneurs, labourers and artisans. Circulation of money in the rural areas was very rare due to the barter system between farmers and property owners. Hence, Cantillon included the urban economy and incorporated labours and artisans to allow a circular flow of income and expenditure (Murphy, 2009).

Francois Quesnay has been credited with the idea of the circular flow of income, even though much of his model was influenced by Cantillon. Quesnay was the first to visualise the flow of economy among three agents: the proprietary class, the productive class and the sterile class (Murphy, 2009; Parto, 2005). A modern economy with more agents and intricate transactions can be explained by adopting the circular flow model. The circular flow model adopted in this book has three major agents: households, firms and government. Households provide the factors of production and receive returns on those factors from firms. This transaction occurs within a market. All the debates surrounding economics revolve around this transaction and the nature of the agents. For example, the classical school of economics hailed the idea of a free market, which was later adopted and modified by the neoclassical school. The neoclassical school believed that the market would determine the equilibrium from demand and supply and that there is no transaction cost. However, the failure of the neoclassical approach to take property rights and transaction costs into account resulted in the debate shifting towards institutions, both formal and informal, to explain market failure. The complex nature of interaction between the economic agents requires an understanding of the entailed institutions like rules, regulations, norms and values.

Institutions are an inherent part of market exchange. It is now an established fact that a market cannot function in the absence of institutions, and nowadays, institutions are entrenched in the economic system more than ever. For instance, it is an institution in the form of government regulation that prohibits the sale of narcotics or restricts child labour. Institutions have been categorised into two groups: formal and informal institutions. Formal institutions are the ones established by formal rules through government regulation, the constitution, formal laws and the legal system. The culture, norms and values of a society are considered informal institutions (North, 1990; Boettke & Coyne, 2009). Formal institutions are deeply embedded in the economic policies we see today. They set policies and regulations in the market so that one group cannot accumulate at the cost of others. Again, when someone or some group breaches the policies, formal institutions punish them through the legal system of the state. Formal institutions hence create an enabling environment for maintaining an equal and just economic system within society. Informal institutions, on the other hand, have often been left out of mainstream economic theories. While formal institutions restrict certain businesses and market exchange, it is the informal institutions, or the societal culture and norms, which shape the boundaries. Formal rules and laws can only work in a system when it is based upon the culture and societal norms (Posner, 1998; North, 1990; Hodgson, 2006).

The study of institutions became of particular interest in terms of economic policies when African and Asian countries that had been under European colonial power failed in their quest for economic development. Policies that powered the European states were implemented in these nations, yet they crumbled and only aggravated the situation over the years. The very transformational path that had worked for the colonial powers failed miserably in the countries they had ruled for hundreds of years. The failure of both the market and the government called for a retrospection of the policies. This failure in the South reinforced the idea that economic policies cannot work under the impression of a “rational economic being and society”. Different societies take different paths in forming states, and hence indigenous solutions are required. State formation is important in this regard. Europe saw a rapid transformation from a communal state to a feudal state and finally a feudal state to a capitalist one. This transformation was reflected in its economic prosperity. On the other hand, the countries colonised by the Europeans took another path towards the formation of their present state, and this was strikingly different from the European one.

State formation depends on people’s capacity to articulate and exercise power, which requires the existence of a vibrant civil society and strong democratic political culture (Haque, 1997). The colonial legacy of discouraging the burgeoning of a strong civil society is still prevalent in developing countries. As a result, accountable and transparent government has not been established yet. Rather there exist feudalistic social relations that perpetuate patron–client relations, creating barriers to the development of societal relations irrespective of family, race and class, which ultimately impede the formation of strong civil society. Thus, the common feature of feudalistic class and caste based social structures in developing countries prevents people from having a “social contract” that binds its citizens with the state. During the colonial period, the institutions of developing countries were established by the colonisers in order to extract resources. The politics, economy and administration of post-colonial countries are influenced by the colonial legacy. Most of the colonial arrangements are still in functioning that are extractive in nature. Colonisers were the exploiter. They created an intermediate class to perpetuate their rule over and exploitation of the colonies. The later politicians, administrators and policymakers in post-colonial countries have come from this intermediate class. Political regime is associated with a host of conflicts and confrontations amongst these classes. The rise of a new intermediate class during the post-colonial period has fuelled this conflict. The winning class always tries to suppress the other. The perverted competition of the intermediate class in terms of gaining economic and political power has left little room for the citizenry. The state fails to become a citizen state in the true sense. This absence of a strong state creates a despotic form of government whereby the state becomes omnipotent. This is one of the main reasons for the deep-rooted undemocratic political culture in most developing nations—in Asia, West Africa, Latin America and the Middle East (Haque, 1997). As a result, the state has become unresponsive to the public’s demands and safeguards the interest of the ruling class. This ruling coalition is comprised of politico-bureaucratic-military oligarchy keeping the branches of the state—legislature, judiciary and executive—unrepresentative. As a result, a centralised government with bureaucratic authoritarianism and undemocratic culture is prevalent where the general populace remains excluded but the executive enjoys absolute power.

The economic policies have followed the extractive nature of the state–citizen relationship in developing countries. Ordinary people have no participation in policymaking. The policies are chosen by the political leadership since, in most cases, they enjoy absolute power. Often this leadership acts as benevolent guardians and make the policies based on their beliefs, leaving no room for ordinary citizens’ participation (Krueger, 1994). As a result, the extractive nature of colonial structure has endured and society is still far from being a public society. The nature of both political and economic institutions in developing countries is extractive (Acemoglu & Robinson, 2012).

This extractive nature of institutions leads to policies that are also extractive and serves the interests of the powerful ruling class. As a result, ordinary people have remained excluded from the policies and the state, whereas the powerful group has become tantamount to the state itself. The economic features of developing countries include a larger informal economy, a widespread primitive accumulation process and the use of state power to create and dissipate rent amongst the powerful factions (Khan, 2005). The informal channel of transactions and the primitive accumulation process have created an environment of economic activities based on patron–client relations. A powerful group maintains and controls the economy. This network has a kind of absolute power in policy formulation, with citizens outside this group being excluded. This clientelist group uses the state’s monopoly power to meet their vested interests. They formulate and reform the policies that fulfil their interests. Thus, the developing state apparatus has little connection with the citizenry.

Since the relations between state and citizen have not been based on equal power structures, undemocratic, authoritarian and despotic governments make the state policies that safeguard their regime. It is observed that the economically and politically powerful class supports the governments that set lower taxes but provide rents to them (Acemoglu, Ticchi & Vindigni, 2011). As a result, the tax regime in most developing countries remains regressive; ordinary people bear the major share of the tax burden, but upper-class, powerful people enjoy tax evasion and tax exemption as the norm. Besides, a major portion of government expenditure goes to unproductive sectors— such as salaries and allowances for public servants, which are unnecessarily large. Furthermore, in most developing countries, the tax–GDP (gross domestic product) ratio as well as the amount of income tax is very low. The government, in most of these countries, has failed to impose income taxes on high-income people. The powerful coalitions always want a state that provides all facilities to their establishment.

The COVID-19 pandemic has changed the world of economic policymaking to the extent that it will never be the same, far beyond any typical economic recession. This pandemic has caused a major disruption in the demand–supply value chain along with a closure of economic activities—mobility of factors from, and return to, households and firms—by governments. Moreover, the pandemic is a public bad, and the free-market system is yet to come to terms with such public bads. Employment has shrunk significantly because of the pandemic. As a result, income has been eroded, which damages the purchasing power of the population. Mass hoarding of essential products by the higher income population has created a shortfall and increased the prices of those goods. The healthcare sector in developing countries were already in a poor shape, lacking modern technologies and equipment. COVID-19 shows the potential for global poverty to rise further to the highest rate in comparison to the other recent global pandemics. To be exact, the number of people living in poverty may increase by 420–580 million (Sumner, Ortiz-Juarez & Hoy, 2020). On the other hand, the World Bank (WB) estimates that the population living in extreme poverty (income less than $1.90 per day) will rise by 40–60 million by the end of 2020. In addition, global poverty could increase by 8.23 percent to 9.18 percent. The World Bank predictions suggested that a global recession, triggered by COVID-19, might cost 70 percent of the employment in emerging and...