William Gumede | Manageable inflation and sustainable exchange rates are crucial for development

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Prudent macro-economic policy, especially the management of monetary, fiscal and public debt is crucial in developing countries, says the writer. Photo: Getty Images/Gallo Images
Prudent macro-economic policy, especially the management of monetary, fiscal and public debt is crucial in developing countries, says the writer. Photo: Getty Images/Gallo Images

Developing countries often pursue persistent deficit spending which, over time, balloons into large national debts and sees the countries pay the price through rising levels of poverty, underdevelopment and financial instability, writes William Gumede.


Prudent macro-economic policy, especially the management of monetary, fiscal and public debt, is more crucial in developing countries that want to catch up to or surpass industrial countries in terms of development.

In the postcolonial period, many developing countries that genuinely pushed broad-based development, fell short when they neglected fiscal and monetary discipline, undoing their development efforts.

Many developing countries put little focus on curbing inflation, keeping exchange rates stable or managing public debt levels. They often allow large budget deficits, where expenses exceed revenue by huge margins.

Developing countries often struggle to manage their budget deficits, current accounts and exchange rates. Many developing countries pursued persistent deficit spending which over time, ballooned into large national debts.

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The result is that these countries pay the price in rising levels of poverty, underdevelopment and financial instability.

Setting developmental interest rates – which promote the outcomes set out in the national industrial or developmental plan, keeping inflation manageable and setting sustainable exchange rates, are crucial for development.

Japan's policy post war

Many developing countries can learn from Japan's developmental monetary policy in the post-war period. 

The Bank of Japan (BOJ), the central bank, operated with reasonable autonomy during the post-war period. The BOJ adopted a strategy of reducing the volatility in the country's currencies by building up large international reserves.

In the post-war period, Japan focused its monetary policy on promoting "export- and investments-led growth", focusing determinedly on ever-diversified exports.

A pillar of the BOJ's monetary policy was called "window guidance". This is when the central bank gives credit quotas to commercial banks, which they must channel to specific industries that are prioritised by the government as growth sectors.

The BOJ would directly communicate the industries that should get quicker loans, thereby directly influencing the activities of commercial banks. Japan's Ministry of International Trade and Industry (MITI) managed the allocations of foreign exchange to companies, with which they bought raw materials or equipment.

Throughout the post-Second World War period, Japan undervalued its currency to encourage export manufacturing. Then, from the 1970s, the focus became currency stability.

The government, until the 1950s, maintained a balanced of payments equilibrium, maintaining similar levels of investments abroad to foreign investment locally.

The country accumulated large foreign reserves and the country's citizens were encouraged to save. The government maintained price stability – targeting inflation at 5.5% per year. The Japanese government implemented a balanced budget principal.

Only in 1965, when the Japanese economy experienced a recession, did the government, for the first time, introduce an expansionary fiscal policy, financing a budget deficit with a national bond. From 1966 to 1973, the government financed a deficit on the capital accounts, through the issuing of a national construction bond.

Throughout the period, the Japanese government emphasised currency and price stability. The government maintained a low interest rate policy throughout the high growth phase and contained inflation. It also eschewed used tax increases to finance budgets and channelled savings to support targeted export manufacturing, infrastructure and housing.

Lessons from Brazil 

In contrast, Brazil's post-war monetary policy approach is a salutary lesson for developing countries not to copy. In Brazil, the military took power in 1964 and ruled until 1985. The military government prioritised high growth rates to maintain support.

The high initial growth rates – from 1960 to 1980 - came through state investments in infrastructure, telecommunications, mining and atomic energy.

However, the high economic growth rates came with high inflation and large budget deficits. From 1981 to 1994, growth slowed down, and was accompanied by hyperinflation and large deficits. Throughout the period from 1960 to 1994, Brazil's central bank was not independent.

Brazil fell into a balance-of-payments crisis in the early 1970s as global demand for its commodities slumped because of slowdowns in industrial country economies buying its commodities. The government pursued import substitution industrialisation, economic diversification and self-sufficiency.

The costs of this conversion were paid by foreign loans. The plan was that over time, a structure in the economy would materialise, whereby more local products would be produced for export, and the foreign earnings would pay for the accumulated debt.

The Brazil government ran large current account deficits. However, foreign debt became more expensive to repay because of higher interest rates charged by lenders. By the mid-60s until the early 1970s, the government increased taxes to plug deficit holes.

By 1983, Brazil had the largest foreign debt of any country in the world – standing at US$92bn. The government responded by hiking interest rates to record levels. The government also repeatedly devaluated the currency, which increased inflation. Efforts to diversify local production of consumer goods at least were pedestrian.

Until 1964, Brazil had no official central bank. In 1964, the government created the Central Bank of Brazil (CBB), which was not independent. The Central Bank of Brazil was given formal independence only in 1994.

The International Monetary Fund and western commercial banks put pressure on the government to introduce a structural adjustment programme, adopted by the country's legislature in 1983, which included reducing inflation, cutting wage increases and privatising state-owned entities.

Sweden's prudent policies 

Sweden, as a post-war left of centre government governed by the Social Democratic Party in the period after the Second World War until the end of the 1970s, maintained prudent monetary and fiscal policies to finance the welfare state.

In 1951, Swedish trade union economists Gosta Rehn and Rudolf Meidner, at the Swedish Trade Union Congress, designed what would be called the Rehn-Meidner economic model, which was based on high growth, low inflation, full employment and income equality.

The Swedish model was based on a “third away” between Keynesian, central planning and neoclassical economics. At the heart of the Swedish model was a growth policy, based on disciplined macroeconomics, with price stability, but still advocating for fair wages, through using an active labour market policy.

Throughout this period, the Swedish central bank, the Riksbank, had both functional and institutional independence, and was one of the agencies that were directly reporting to Parliament.

In the Swedish model, “expansionary macroeconomic policy measures are combined with selective fiscal measures and with regulation to conquer inflation”.  The Swedish Social Democratic Party reduced possible rising inflation, current deficits and overvaluation of the currency that would result from expansionary policy, by “regulation, including informal incomes policy, and by extraordinary fiscal measures” to “moderate price and wage increases in the most overheated industries”.

The government prioritised budget surpluses. The currency was kept consistently lower than competitors.

In the Swedish model, during recessions, a countercyclical fiscal policy, reducing spending and raising taxes during boom times, and increasing spending and reducing taxes during downtimes, was still part of the macroeconomic arsenal.

During recessions, the temporary use of budget deficits, moderating wage increases and selective employment subsidies in weaker industries were practical options.

To prevent inflation, the government used prudent public finance management. It pursued strict fiscal policy, focusing on generating budget surpluses.

Indirect taxes 

It particularly used indirect taxes to hold down inflation. The country introduced consumption taxes – taxing people when they spend money on goods and services, rather than on income or profits. Sweden in the 1950s to the 1970s began to coordinate wage bargaining, to protect weak industries and to manage inflation.

The government managed an active labour market policy: comprehensive industrial skills, training, education, life-long adult-education programmes to cushion the "losers".

Through effective coordination of the economy, the government continually shifted employees from low-growth to high-growth sectors. 

A core part of the Swedish welfare state was universal education, health and pensions. Private property rights and the freedom of companies to trade internationally were pillars of the model.

In the mid-1970s, the Swedish Trade Union Confederation (LO), an ally of the Social Democratic Party, proposed the establishment of employee-controlled wage-earner funds, which would give trade unions a direct say in the investment decisions of listed companies.

Organised business saw it as a "collectivism of corporate ownership. More importantly, the disagreement over the wage earner proposals would collapse the famous Swedish tripartite consensus model. The Swedish Social Democratic Party lost power in the 1976 elections.

Balancing competing objectives

The lessons for the ANC and South Africa is that monetary policy is about "balancing the competing objectives of economic policy: price stability, exchange rate stability and free capital mobility".

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Expansionary fiscal policies, whereby they increase public spending to stimulate aggregate demand in the economy, must always be accompanied by judicious public spending. Unchecked government spending may cause harm, including rising inflation and push out private investment.

Large budget deficits, caused by the government spending more than it collects in revenue and grants, causes macroeconomic imbalances. Many developing countries often hold their currency at too high a rate for the state of the economy. Finally, reasonably independent central banks have been at the core of many countries that have, in the post-Second World War period, pursued developmental monetary strategies.

- William Gumede is Associate Professor at the School of Governance at the University of the Witwatersrand.

*This is an edited extract from an Occasional Paper, Developmental fiscal and monetary policy: Post-Second World War Lessons from Selected Social Democratic States, Developmental States and Populist States, for the Inclusive Society Institute.


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