Economists are notorious for their contradictory advice so much so that one chief executive of a developed country is reported to have requested the services of only a one-handed economic adviser. However, he did not realise that difference in advice usually reflects not difference in economic concepts, but in assumptions.
The situation is different in Pakistan. Some of the economic managers who currently hold, or have held in the past, important government positions, either do not understand the economic policy linkages of the components of a coherent macroeconomic policy framework, or deliberately choose one set of data and concentrate on one instrument of policy to conceal the truth or confuse the audience.
It may be worthwhile to explain in simple terms what our national economic objectives are and what is the set of policies that could be used judiciously to achieve those objectives. Broadly, our economic objectives are to realise the highest rate of economic growth and keep inflation at the lowest possible level and to do so by maintaining viability and sustainability of the balance of payment. Division of labour can promote specialisation which is necessary for the formulation of a sophisticated set of economic policies that, of course, must work in harmony with each other through their effective coordination.
The three main policy instruments to achieve these objectives are fiscal policy, monetary policy and exchange rate policy. A judicial blend of these three policies on a consistent basis could help realise the national economic objectives. Their mismanagement can lead to economic decline, high rate of inflation and vulnerability of the balance of payment which is the case in Pakistan.
While an economic management team should work cohesively together, fiscal policy should be the main responsibility of the Ministry of Finance, monetary policy falls in the jurisdiction of the State Bank of Pakistan and the Ministry of Commerce should take care of the balance of trade. The Planning Commission’s main task is to develop a growth strategy in coordination with all these institutions and other economic departments of the government, including the provincial governments. The exchange rate policy should be formulated collectively and implemented by the State Bank of Pakistan. This division of labour should not take the shape of institutional conflict or disharmony and must be coordinated effectively without subordination of one organ to the other or one policy to the other. A legal framework is in place for such coordination.
The trouble starts when one organ of the government begins to dominate the other or one policy begins to subordinate the other policies for its limited purposes. That, in fact, is the real story of the economic mismanagement of Pakistan. The Ministry of Finance as an institution and fiscal policy as a policy have dominated the economic scene for a long time. The result has been that both the monetary policy and the exchange rate policy have been framed for a long time by the Ministry of Finance as subservient tools of fiscal policy.
The Ministry of Finance was unable to broaden the tax base and improve tax administration in order to generate enough revenues to meet the large defence needs, finance rising civilian current expenditure and launch ambitious public-sector development programmes. It began to use monetary policy and the external sector to finance uncontrolled public expenditure and resorted to reckless internal and external borrowing to meet its budgetary resource gap. In the short run, it worked as a solution of fiscal problems, but in the long run, it became a monster of a problem for the budget itself. This borrowing fuelled inflation, crowded out the private sector and pushed up interest rates. Rising volume of government borrowing and consequent inflation, high interest rates and fast exchange rate depreciation added to government debt burden and debt servicing liabilities. Instead of changing the course, the Ministry of Finance began to indulge in more and more expensive domestic and foreign borrowing, permanently trapping itself in a vicious circle.
The country is by now in a fiscal policy trap. The government is running a huge deficit in its fiscal operations. It is unable to reduce the losses of public-sector enterprises and commodity operations, is stuck with rising debt servicing and large defence expenditure, and is unable to expand the tax base and raise the tax-GDP ratio. It has to borrow more and more but that increases inflation which in turn puts pressure on interest rate and the exchange rate. Higher interest rates and depreciation of the exchange rate lead to widening of the budget deficit.
The Ministry of Finance, being in the driver’s seat, subordinates monetary and exchange rate policies to the requirements of the budget. The former leads to excessive money supply and inflation and the latter contributes to the vulnerability of the balance of payment. This method of financing the budget has resulted in stagnation in growth, inflation in prices and vulnerability of the balance of payment.
It is the fiscal policy that causes inflation to rise, the interest rates to go up and exchange rate to depreciate; and the causation is not the other way around. While the fiscal policy continues to inflate the economy, maintaining interest rates at below market level will neither help the budget nor the economy in the long run. Keeping exchange at below equilibrium level will not help the budget. Exchange rate depreciation actually helps the budget on a net basis so far as government external borrowing exceeds its foreign currency debt repayments. The root cause of the problem is the budget and without blocking the highly elevated floodgate of budget mismanagement the government will not succeed in stopping the adverse effects of its flooding on low-lying economic policies.
The government economists need to understand that in the case of Pakistan the budget is the cause of inflation, high interest rates and exchange rate depreciation, and the treatment of the ailing economy will be effective only if it is started from that end.
The writer is a former governor of the State Bank of Pakistan.