Macroeconomic Stability: The More the Better?

1 Macroeconomic POLICIES IM-proved in a majority of devel-oping countries in the 1990s,but the expected growth benefits failed to material-ize, at least to the extent that many observers hadforecast. In addition, a series of financial crisesseverely depressed growth and worsened is the relationship between these develop-ments? This chapter argues that both slow growthand multiple crises were symptoms of deficienciesin the design and execution of the pro-growthreform strategies that were adopted in the 1990swith Macroeconomic stability as their 1 reviews how Macroeconomic stabilityevolved during the 1990s. Section 2 evaluates thisexperience from the perspective of promoting eco-nomic growth , examining how a policy agenda thatfocused on Macroeconomic stability turned out tobe associated with a multitude of crises.

2 Section 3draws lessons, which essentially concern the depthand breadth of the macro reform agenda, the needfor attention to Macroeconomic vulnerabilities, andthe importance of policies outside the macroeco-nomic Macroeconomic Facts of the1990sHow did Macroeconomic stability evolve over the1990s? Answering this question requires, first, a clar-ification of the meaning of Macroeconomic insta-bility and of how to measure it empirically. Con-ceptually, Macroeconomic instability refers to phe-nomena that make the domestic macroeconomicenvironment less predictable, and it is of concernbecause unpredictability hampers resource alloca-tion decisions, investment, and instability can take the form of volatilityofkey Macroeconomic variables or of unsustainabilityin their behavior (which predicts future volatility).

3 To examine the evolution of macroeconomicstability, we look at the behavior of macroeconomicoutcome variables including the growth of real out-put, the rate of inflation, and the current accountdeficit. It focuses on the volatility of the growth rateand the levels of inflation and the current in the behavior of these endoge-nous variables can reflect changes in the macroeco-nomic policy environment as well as exogenousshocks. Thus to distinguish the roles of these twofactors we look at the behavior of fiscal, monetary,and exchange rate policy variables as well as at realand financial exogenous shocks to of Macroeconomic OutcomesDeveloping countries have traditionally experiencedmuch greater Macroeconomic instability than indus-trial problem is widely perceived tohave worsened,4but in fact the volatility of develop-ing countries key Macroeconomic aggregatesdeclined in the example, the medianMacroeconomic Stability: The More the Better?

4 95 Chapter 4 Korea) but also countries whose growth volatilitydeclined (such as Madagascar, which suffered a largedrop in GDP in 1991; Mexico; and Ecuador).Thereis evidence that this crisis-type volatility is signifi-cantly more adverse for growth than normal volatil-ity (Hnatkovska and Loayza 2004).10 Inflation rates improved in the 1990s. Amongmiddle-income countries the median annual infla-tion rate declined from a peak of 16 percent in 1990to 6 percent in 2000. Among low-income coun-tries, inflation peaked during 1994 95 in the wakeof the devaluation of the CFA franc, and thendeclined (figure ). The incidence of high infla-tion among developing countries declined sharplyafter peaking in 1991 (figure ). But over the1990s as a whole, the number of developing coun-tries experiencing average inflation higher than 50percent was no smaller than in the things being equal, reduced aggregatevolatility and lower inflation probably improved theincomes of the poor.

5 The inflation tax tends to falldisproportionately on poorer households, whichECONOMIC growth IN THE 1990s96standard deviation of per capita gross domestic prod-uct (GDP) growth fell from 4 percent in the 1970sand 1980s to about 3 percent in the 1990s, althoughit remained significantly higher than the comparablefigure for industrial economies ( percent) ( ).6,7 The reduction in GDP volatility was wide-spread but far from universal: of the 77 developingcountries for which complete information is avail-able for 1960 2000, about a third (27 countries)experienced more volatile growth in the 1990s thanin the 1980s. In turn, the volatility of private con-sumption growth also declined relative to the previ-ous decade in low-income developing countries. Inmiddle-income countries, however, consumptionvolatility remained virtually unchanged at the recordhighs of the reduction in the aggregate volatility of GDPgrowth concealed the increasing role played byextreme instability (figure ).

6 In the 1990s, largenegative shocks accounted for close to one-fourthof total growth volatility, against 14 percent in the1960s and 1970s and 18 percent in the increasing incidence of growth crises affectednot only countries whose growth volatility rose(such as Indonesia, Malaysia, and the Republic of012345 All countries(97)Industrialcountries (20)Least developedcountries(77)Middle-incomecount ries(41)Low-incomecountries(33)1966 701971 801981 901991 2000 FIGURE growth Volatility, 1966 2000(percent, medians by country income group)Sources: World Bank, World Development Indicators; Hnatkovska and Loayza 701971 801981 901991 2000 NormalExtreme CrisisBoom FIGURE of GDP growth Volatility,1961 2000(percent, mean of 77 developing countries)Source:Author s own elaboration using data from World Bank WDIand Hnatkovska and Loayza (2004).)

7 Note: Extreme shocks are defined as those exceeding two standarddeviations of output growth over the respective decade. Total volatil-ity = Normal + Extreme; Extreme = Crisis + few or no financial assets to shelter them againstrising prices, and whose wage earnings typically arenot fully indexed to this and otherchannels, higher aggregate volatility is empiricallyassociated with worsening income median current account deficit amongdeveloping countries decreased slightly in theMACROECONOMIC STABILITY: THE MORE THE Better? 971990s, although there was a contrast between mid-dle- and low-income the former,the median current account deficit/GDP ratio wasabout one percentage point lower than in the 1970sand the latter, it rose by about half apoint in relation to the 1980s to exceed 5 percentof GDP in the 1990s (figure ).

8 0510152025301961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 Inflation rateIndustrial countries (20)Least developed countries (77)Middlie-income countries (41)Low-income countries (33)FIGURE Rates, 1991 99(GDP deflator, medians by country income group)Source:World Bank, World Development 50%Above 80 %1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 FIGURE Inflation in Developing Countries, 1961 99(relative frequency, percent) Source:World Bank, World Development early 1980s to 2 percent of GDP in the 1990s,before rebounding to about 3 percent by the endof the decade. The fiscal correction was particu-larly pronounced among middle-income coun-tries (figure ).

9 Since the overall fiscal balance is affected by thetrajectory of interest rates on public debt (which isbeyond the direct control of the authorities), theprimary balance likely offers a more accurate meas-ure of a country s fiscal stance. Its evolution over the1990s shows clear increases in surpluses, particularlyafter 1995 (figure ). By the end of the decade,the median developing country held a primary sur-plus, although a much more modest one than thattypical of industrial is more difficult to gauge monetary stability,given the diversity of monetary arrangements acrossdeveloping countries and over time. One rough meas-ure is the resort to seigniorage that is, money financ-ing of the deficit. Measured by the change in themoney base relative to GDP, seigniorage collectionrose in the late 1980s and early 1990s, and thendeclined in middle-income and (more modestly) low-income economies (figure ).

10 The pattern is roughlysimilar to that of the inflation rate (figure above).The diversity of exchange rate arrangementsacross countries makes it hard to gauge trends inexchange rate policy for developing countries as aECONOMIC growth IN THE 1990s98 Stability of PoliciesConventional indicators of policy stability alsoimproved over the 1990s. Most notably, the over-all fiscal deficit of developing countries shrankfrom a median value of 6 7 percent of GDP in 6 5 4 3 2 1012%All countries(70)Industrialcountries (17)Least developedcountries (53)Middle-incomecountries (32)Low-incomecountries (19)1966 701971 801981 901991 2001 FIGURE Account, 1966 2000(percentage of GDP, medians by country income group) Sources:World Bank, World Development Indicators; IMF, BoP4 Note: The countries featured are those for which data are available over the entire periodshown.