Reinterpreting Pakistan's “Economic Crisis”

The essence of the proposal is the consideration that a government that issues its own currency faces no financial constraints or solvency risk. This implies that the usual “government budget constraint” has no economic content.

The writers of the document entitled A Reinterpretation of Pakistan's “Economic Crisis” and Options for Policymakers Jesus Felipe, William Mitchell, and L. Randall Wray tried to present an in-depth analysis of Pakistan's macroeconomic situation.

It argues that although the stabilization program signed with the International Monetary Fund in November 2008 could restore some “macroeconomic stability”, it will depress the investment and unemployment outlook, and will not create the conditions that Pakistan needs for long-term development.

One cannot deny the fact that Pakistan is currently undergoing an economic crisis that requires firm and decisive policy action if it is to be overcome quickly as well as to maintain social stability and equity. It is presently under the grip of apart from terrorism, excessive inflation; lack of foreign reserves to support import levels ; lack of productive capacity building; and significant waste of labor resources through unemployment and underemployment.

In a recent analysis of Pakistan's fragile situation The Economist wrote in

its 23 October 2008 issue:

… Pakistan faces economic meltdown …. The economy is close to freefall. Inflation is running at about 30%. The rupee has devalued by about 25% in just three months. The fiscal deficit is a whopping 10% of GDP. Foreignexchange reserves cover just six weeks of imports. A $500m Eurobond matures next February, but the market has already decided it is junk. The country needs at least $3 billion in short order, and a further $10 billion over the next two years to plug a balance-of-payments gap. Without it, default abroad might well coincide with political anarchy at home…

In the very next issue it was emphasize that:

Without foreign help, Pakistan won't be able to afford its imports, repay its debts, or quell the insurgents encamped within its borders. Thanks to protracted power cuts, it cannot even keep the lights on in its towns and villages. It is not, in other words, a state in full command of itself. And yet despite these dispiriting facts, or perhaps because of them, Pakistan is acutely sensitive to any infringement of its sovereignty. Those outside powers in a position to help it, from the International Monetary Fund to the American military, are as likely to offend its pride as to earn its gratitude.

In recent months Pakistan's economy has deteriorated quickly and the Pakistan Government has now formally requested $US15 billion in financial assistance from the International Monetary Fund (IMF) using the IMF's Emergency Financing window. The reality is that it will likely receive only around $US2 billion per year for three years as a reflection of its Statutory Drawing Rights quota.

The overriding view among economists is that there is a gross imbalance between insufficient aggregate supply and excessive aggregate demand in Pakistan (both moving in opposite directions), which has generated inflation and rising imports. These problems have, in turn, seen a rapid depletion of foreign exchange reserves and sharp markdowns in the rupee.

The financial problems, however, should not be seen in isolation from the real problems — the constrained supply and the persistently high rates of labor underutilization for doing so would narrow the range and scope of policy options and, ultimately, would limit the capacity of the economy to redress the real problems.

Assessment of the IMF Program and Its Conditionalities

When the paper was being prepared, an agreement with the IMF had just been reached where a 23-month “stand-by arrangement” amounting to around $7.6 billion had been made available to Pakistan to support its “economic stabilization program” on certain conditions and objectives. This agreement is already influencing Pakistan's policies, however, the paper argued that there was yet latitude within the constrained policy environment to pursue more sustainable outcomes than those established by the limited horizons set by the IMF agreement.

The problem with the Fund's approach is that it is less than clear on: (i) the nature of currency sovereignty; (ii) the nature and financing of budget deficits; and (iii) the nature and financing of trade deficits, the authors argued. “This matters because while it is true that Pakistan's problems are largely the result of misguided policies, it does not mean that the only solution available is to subject the economy to an austerity program.”

Further, the working paper believed that the IMF program does not correctly portray the source of the inflation pressures, or the constraints on economic development. Ironically, Pakistan faces high inflation and insufficient progress toward development even as it experiences persistent and significant unemployment of its domestic resources. Hence, what Pakistan needs to do over the medium term in order to achieve sustainable development mostly requires a mobilization of domestic resources to improve incomes and reduce supply bottlenecks through expansion of domestic capabilities.

Given substantial levels of redundant resources, it should have been obvious that Pakistan's inflationary bias could not be a simple matter of excessive demand. Thus, in appraising the inflationary impact it is incorrect to presume that fiscal policy has been excessively expansionary. Budget deficits can result from insufficient aggregate demand—with the budget deficit endogenously expanding via revenue losses and spending increases when gaps in private spending appear. Using budget deficits as evidence of excessive expansionary policy is therefore erroneous, unless the deficits have pushed the economy beyond full capacity use of its resources. For this reason, fiscal restraint may not be the medicine that is required in a situation in which a country is actually living below its means—as indicated by idle or underutilized resources.

From the orthodox perspective the consequences for Pakistan of having balance of payments (BOP) problems are straightforward. When Pakistan encounters a BOP problem before short-term capacity utilization is reached, demand is curtailed, disguised and open unemployment increase, and capital accumulation has to be reduced. This leads, in the long run, to a relative deterioration of the country's export potential compared with that of its main competitors. This situation tends to lead to a vicious circle with further BOP problems.

The paper recognized the problem but did not endorse the orthodox solution. Given that Pakistan operates with what they defined below as a “modern money regime” (more about it later) that includes flexible exchange rates, the informal document considered that it had sufficient domestic policy space to pursue an alternative, sustainable growth path even if it meant expansion of the current account deficit and depreciation of the currency.

Of course, such a recommendation was for the medium term which is not something that can be done in a crisis—nor can continuous currency depreciation be sustainable. While there is no strict BOP growth constraint in a flexible exchange economy in the same way that one exists in a fixed exchange rate world, the external balance still has implications for foreign reserve holdings via the level of external debt held by the public and private sector. Moreover, the evidence shows that, in the long run, no country can grow faster than the rate consistent with balance on the current account. Sooner or later the market penalizes the country and attracting capital inflows from abroad becomes very difficult.

The IMF conditions will reduce the capacity of the government itself to engineer a solution to the problems of inflation and falling foreign currency reserves without increasing the unemployed buffer stock. While the IMF statement suggests it is keenly aware of the need to deploy a “socially acceptable” solution, the paper considered that a policy strategy based largely on fiscal austerity will create unacceptable levels of socioeconomic hardship.

The paper reminded the international crises of 1990s and 2000s and said that fiscal discipline had not helped developing countries to deal with financial crises, unemployment, or poverty even if they had reduced inflationary pressures. Therefore, the paper emphasized that It was necessary to create an alternative package of policies that would maintain price stability while creating jobs and raising domestic living standards as a way to reduce social unrest. This has to be done while using FDI to build productive capacity rather than to finance consumption.

Another government policy emphasis has been to stabilize the exchange rate. The typical method used in many nations is to target inflation, reduce budget deficits, and encourage exports. This is exactly the logic of the current IMF agreement. It is possible that this package of policies can generate short-run benefits by allowing accumulation of foreign currency reserves that can be used to appreciate the currency. However, this outcome conflicts with promotion of long-run economic and political sustainability. The best way to stabilize the exchange rate is to build sustainable growth through high employment with stable prices and appropriate productivity improvements. An export-led growth strategy based on restraining wage increases sacrifices domestic policy independence and places maintaining a stable exchange rate as a top policy goal.

The paper suggested as to how the ADB can help Pakistan to overcome the crisis. It said, among other things that criticized the IMF policy, that ADB could contribute to the design of an investment program to achieve full employment.#