Macroeconomic and Monetary Policy Issues in Indonesia

Akhand Akhtar Hossain

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781136307256
• Edition: 1
• Topic: Volkswirtschaftslehre
• Subtopic: Makroökonomie

Following the acquisition of its sovereignty from the Netherlands in 1949, Indonesia experienced serious economic and political problems during the 1950s and 1960s, before entering a three-decade-long period of rapid economic growth. Hard-hit by the financial crisis of the late 1990s, Indonesia undertook a wide range of economic and financial reforms. These reforms served to prepare it well for the 2007-08 global financial crisis, through which Indonesia passed relatively unscathed.

Drawing on empirical research, this book presents a comprehensive empirical study on the key macroeconomic relations and monetary policy issues in Indonesia. The book analyses monetary, fiscal and exchange-rate policies, looking at their interactions and impacts on the economy. It demonstrates how important macroeconomic management for monetary and financial stability is to sustained national economic growth and development.

Data from the 1970s is compared and contrasted with 1950s data to analyse macroeconomic policies and issues in an historical context. Statistical and econometric techniques are juxtaposed with general empirical results to supplement informative discussion of macroeconomic and monetary developments. This book is a useful contribution to studies on macroeconomics and international development, as well as Southeast Asian studies.

1
Introduction

At the moment of independence from the Dutch in 1949, Indonesia was one of the poorest countries in Asia. By the mid-1990s it had emerged as an industrial-development success story, which might be regarded by some as surprising given that Indonesia is the most populous nation in Southeast Asia. Indonesia’s development success has been so emphatic that it now has the potential to become one of the dominant world economies by the middle of this century, if not earlier.¹

How Indonesia managed to restructure its production arrangements from subsistence to industrializing-economy status remains an area of research interest. In an historical context, Indonesia’s development strategy differed little from those of its Southeast Asian neighbours. Upon independence from the Netherlands, Indonesia embarked on an inward-oriented development strategy. Its policy goal was rapid industrialization. This strategy took the form of a socialist model of development meaning, in practice, the ‘Indonesianization’ of the economy. The public sector in particular was given the dominant role in economic development. While popular politically, the strategy lacked effectiveness in resource mobilization to achieve and maintain rapid economic growth. Rather, the public-sector-led development strategy created economic inefficiency, gradually transforming an otherwise open economy into a closed one. Government intervention in most economic affairs created a corruption-ridden bureaucracy which suffocated the business entrepreneurship so essential for any country’s economic growth and development.

The most damaging element in this stifling business environment was the ad hoc, populist stance of fiscal and monetary policies. Macroeconomic policy-induced high inflation, caused by expansionary government budgets and money supply, became a major problem from the late 1950s. A major element of expansionary budgets was low taxation revenue, and this then fell sharply during ensuing high inflation, worsening the expansionary problem. Although government spending did not increase much, the falling government revenues inflated budget deficits which were then financed, on the monetary-policy side, by money creation. Under Indonesia’s then fixed exchange-rate system, high inflation subsequently made the real exchange rate² of the rupiah³ heavily overvalued. This unsustainable situation ultimately led the country into a major balance-of-payments crisis during the mid-1960s.

The major political outcome of the economic crisis was a change of national leadership in 1966. The ‘New Order’ government under Lieutenant General Soeharto brought much-needed fiscal and monetary discipline (Hill, 2000). This was achieved through introduction of a package of stabilization and structural adjustment measures. With general acknowledgement that economic performance under the Sukarno regime had been less than satisfactory, the new government was able to build a consensus on the need for rapid economic growth (Booth, 1998).

With the consensus on rapid economic growth in place, the Soeharto government set about introducing policies and measures considered consistent with this national goal. These included moving Indonesia to an increasingly open economy by easing official regulation of trade and capital flows. Sustained economic growth over the next three decades lifted Indonesian incomes until, immediately preceding the 1997–98 East Asian currency–financial crises, the country as a whole had reached lower-middle-income level.

Indonesia inevitably experienced several external shocks throughout its phase of economic opening. Arguably the Indonesian economy was disrupted more than any other in its region by the monetary-financial events of 1997–98. While other countries in the region recovered quickly, the Indonesian recovery took about five years. From 2005 onwards Indonesia’s economy has grown at about 5 per cent per annum. All indications are that the economy has moved to a higher growth path of about 6 per cent per annum since 2009. This deep, extensive experience of externally induced economic disruption has led development practitioners to consider Indonesia one of the leading cases from which salutary lessons can be drawn, especially in terms of macroeconomic management and adjustment to external shocks under various policy regimes and institutional arrangements. The key issues that provide focus for such studies are highlighted next.

Open-economy macroeconomic management

Macroeconomic stability is the core concern of policy-makers in an open economy. The task of policy-makers is to design and implement economic policies that sustain both internal and external balance. Internal balance involves full employment of the country’s productive resources and the maintenance of price stability, meaning low and stable inflation. External balance is achieved when a country’s current account deficit or surplus remains sustainable and consistent with internal balance. Some policy-makers want to achieve other policy objectives such as improving income distribution and extending the external-balance target beyond current-account balance to the entire balance of payments (Krugman and Obstfeld, 2010).

Macroeconomic management in the end is both science and art. It involves deployment of economic policy instruments to steer an economy along a sustainable growth path. As sustained economic growth raises the average standard of living of the people, responsible and effective macroeconomic management is essential in a country’s economic, social and political stability. The critical importance of macroeconomic management is clearest when regarded from a longer-term growth perspective.

Economic growth theories suggest that long-term economic growth originates from capital accumulation, labour force growth and technological progress. The collective growth experience of developing economies suggests, however, that short-term economic factors must also influence economic growth because of their implications for saving, investment and production efficiency (Montiel, 2003). Macroeconomic management is concerned with the design and implementation of policy measures designed to reduce the frequency with which macro economic imbalances occur. Macroeconomic management also involves deployment of remedial measures to shocks – structural or policy induced or both. As structural shocks cannot easily be avoided, one basic principle of macro economic management is that policy-makers avoid creating policy-induced economic shocks, whether autonomously or as response to structural shocks.

Economists differ on the extent to which this principle should be followed. One debatable issue is the optimal level of policy intervention in a market economy. Historically, this issue has been debated within the rule-versus-discretion policy paradigm. The main advantage of rule-based economic management is that it underwrites economic efficiency by providing policy certainty and stability – although, in practice, rules deployed for economic stabilization tend to be rigid and sub-optimal. In contrast, policy discretion routinely creates uncertainty-induced inefficiency costs in the economy, and in addition imposes a high premium on top of those costs in the event of policy mistakes. Furthermore, policy activism, which often takes a populist form, carries with it the danger of creating macroeconomic crises.

In the general case of developing countries, the issue is whether policy-maker responsibility extends to raising economic growth and stabilizing business cycles in a Keynesian sense, or to establishing an environment within which productive forces are unleashed in response to a created regime of production incentives. In general, the overriding lesson of theory and experience is that, if policy-makers engage in activist macroeconomic management pursuing real objectives such as rapid economic growth and income redistribution, then they have to perform policy tasks of challenging nature, and perform them in such finely balanced ways as to render the challenges almost insurmountable.

In the development literature, the East Asian development model is seen as an application of free-market principles in economic affairs while the state is assumed to bear the burden of maintaining law and order, ensuring property rights and developing economic and social infrastructure. The East Asian development model discourages both political activism and macroeconomic populism. Low inflation, sustainable current account balances and rapid economic growth are the hallmarks of sound macroeconomic management. In the model, deviation from prudent macroeconomic management is treated harshly by market participants. For example, Indonesia suffered from adverse investor sentiment when the private sector crossed the limit of external borrowings, which were unhedged, and when the authorities tempered market principles by sanctioning monopolies to the political elite and patronizing well-connected business tycoons. Consequently, market punishment came in the form of capital flight.⁴ Both for Indonesia and for other countries in the region, the 1997–98 currency–financial crises have had far-reaching economic, social and political implications.

Since the financial crisis of the late 1990s, the Indonesian authorities have undertaken comprehensive economic reforms as suggested and recommended by the IMF under various structural adjustment programmes. However, Indonesia’s reform measures were not completely new. Some of them were initiated in the early 1980s when Indonesia experienced a sharp decline in oil prices that dried up its export earnings and tax revenues. This was the period when some Latin American countries experienced a major debt crisis. Most economists suggested that misguided economic policies caused the Latin American debt crisis, which all but halted economic progress in the region for over a decade (Sachs and Larrain, 1993). Arguably, the 1980s Indonesian reforms mitigated somewhat the 1997–98 crises and imbued the political leadership with an increased receptivity to the more difficult reforms indicated by those crises. The stabilization and structural reform programmes implemented following the financial crisis were costly and painful but necessary for sustaining long-term economic growth.

Following the global financial crisis that emerged from the United States in 2007, the IMF has, apparently, recanted some of its standard stabilization and structural adjustment policies for dealing with macroeconomic liquidity crises. The IMF policies for East Asia in fact came under criticism because they represented the ‘orthodox views’ of classical/neoclassical economists. A widely held view is that restrictive fiscal and monetary policies were not appropriate for solving the short-term liquidity problems encountered by the East Asian countries in 1997–98. It would appear as if, in response to such criticism, liquidity support and policy activism have become IMF policy for addressing the global financial crisis whose ‘knock-on’ effects, at the time of writing in mid-2011, continue to afflict a number of developed countries, mainly in the European Union.

The global financial crisis has created a debate on the issue of whether macroeconomic theories and policies should be revisited to draw implications for the received doctrine on managing small, open-economies in the event of shocks (Blanchard et al., 2010). While the Keynesian prescription of fiscal activism has gained prominence since the global financial crisis, an alternative view is that nothing significant has changed apropos the prescribed role of government in economic management. The standard macroeconomic theories remain adequate to explain the global financial crises and to draw lessons on how to expedite recovery from recession.⁵ For macroeconomic management in developing countries, the lesson is clear and remains orthodox. Indonesia took a long time to recover from the 1997–98 crises. Macroeconomic stability has been achieved and growth has accelerated since 2005. This recovery could be derailed if the authorities opt for policy activism to address smaller, more common shocks that are likely to be transitory. The importance of macroeconomic stability for economic growth in developing Asia has indeed been restated in recent publications of the IMF.⁶

Key themes in macroeconomic management, stability and economic growth

This section reviews a few broad themes of the development literature, followed by some discussion of them in the context of Indonesia. The themes are then analysed by the empirical essays that constitute the chapters of this book’s main body. The concluding section of each chapter draws together the more significant emergent themes and/or policy implications of empirical findings.

Saving, investment and economic growth

Accumulation of capital is the fundamental determinant of economic growth, at least in the early development stages. This point has repeatedly been emphasized by leading economists. For example, Arndt (1987) pointed out that the cornerstone of economic development in its first phase is physical capital accumulation. Nurkse (1953) considered it ‘a necessary condition of progress’. Lewis (1955) shared this view and pointed to the low rate of investment as the key difference between a developed and an underdeveloped economy. This was also a common theme in the writings of classical economists from Adam Smith to Karl Marx. It was later elevated to a central position in the growth theory of Harrod and Domar (Rostow, 1990). In this light, it is perhaps unsurprising that Meier and Baldwin (1957) characterized poor countries as being ‘capital hungry’. Sen (1983:751) is equally forceful in his acknowledgement of the role of capital accumulation in economic growth: ‘Altogether, so far as growth is concerned, it is not easy to deny the importance of capital accumulation or of industrialization in a poor pre-industrial country’.

Solow (1956, 1957), in his classic model of economic growth, however, has shown that economic growth in the steady-state results predominantly from technical progress and not from the growth of per-head capital. For example, according to him, about 88 per cent of economic growth in the United States during 1909–49 was due to technical progress, while the remaining 12 per cent was due to a rise in capital per worker. An implication is that a rise in the rate of saving does not raise economic growth permanently, although it does raise per-capita income in the steady state.

These features of the Solow model have been the basis of a debate on whether East Asian economic growth, based on capital accumulation, can be sustained over time. The debate started initially in the context of the growth process in the former Soviet Union. In the debate, two types of growth process have been identified: intensive and extensive. Intensive growth means that an economy grows because of the growth of total-factor-productivity (TFP) due to technological progress while extensive growth means that an economy grows because of deployment of increasing volumes of resources as inputs (for example, factories and machines) and a higher rate of participation of the labour force (Sarel, 1997).

Economic growth, both in the former Soviet Union and in East Asia, has been extensive in nature, yet with a ‘fatal flaw’. For example, the phenomenal growth of the Soviet economy in the 1950s and 1960s was not sustainable into the 1970s because of diminishing returns to capital accumulation. Capital accumulation in the Soviet Union was concentrated in state enterprises which exhibited no significant technological progress. This retarded growth of the Soviet economy in the 1970s, and its cumulative effects contributed to the regime’s collapse in the late 1980s (Easterly and Fischer, 1994).

Despite the collapse of the Soviet economy, authors such as Easterly and Fischer (1994) did not see any parallel danger with East Asia’s extensive growth process, at least for two reasons. First, the Soviet planned economy had limited substitutability between capital and labour. This created superfluous capital when it was increased disproportionately relative to other factors of production such as labour. That is, given a fixed-coefficient production function with labour (L) and capital (K) as the factors of production, excess capital (or labour) in the absence of accompanying increments of labour (or capital) keeps output (Q) constant: Q^* = f(K^*, L^* + δ) and Q^* = f(K^* + δ, L^*) (δ ≥ 0) (Chiang, 1984). In contrast, the East Asian economies had a higher degree of factor substitutability, which led to better utilization of increased capital. Second, significant technological progress apparently took place in East Asia, making its growth process different from that of the Soviet Union. The extent of technological progress, however, remains a controversial issue. Since the debate started in the mid-1990s, most East Asian countries appear to have drawn policy lessons from the growth processes in the Soviet Union vis-à-vis their particular circumstances. This has been possible because of openness of most economies of East A...