Indonesia: Shifting from monetary to fiscal policy

Hendi Kariawan Jakarta

Indonesia began to become more reliant on monetary rather than fiscal approaches in nation economic policy in the early 1980s. In 1983, the government deregulated interest rate policies and later in 1988 abandoned its planned restrictions on bank permits to encourage growth in the banking sector. Soon after, new banks mushroomed beyond people's wildest expectations.

These developments were the embryo of the monetary collapse in 1997/1998. From 1988 to 1997/1998 connected (intra-group) lending financing escalated, often in blatant violations of prudent banking practices.

Monetary and fiscal approaches are two different economic tools. The monetary approach emphasizes the money supply, money demand and the most important variable, interest rates. Monetarists believe that by controlling the supply and demand of money, a sustainable growth and an optimal equilibrium level vis- a-vis a natural unemployment rate are achievable.

But this approach is not necessarily applicable in all developed and developing countries. One of the few successful stories of a developed country ever applying this approach was the Great Britain of the 1980s

The United States, though arguably unsuccessful in using this approach, has persistently tried to pursue a monetary policy, given its huge debt burden that is financed by massive capital inflows and the status of the U.S dollar as an international currency.

Outside the U.S, the monetary approach certainly does not suit the interests of developing countries as their currencies are not a major component of international reserves globally. Applying a monetary approach without balancing it with a proper fiscal policy can and will lead to economic turmoil. For countries outside the US, a fiscal policy stance is more appropriate to achieve sustainable economic growth and development; and Indonesia is no exception to this rule.

Fiscal policy, meanwhile, emphasizes aggregate demand to stimulate economic growth. This approach was used to successfully fix the global economy after World War II and John Maynard Keynes was its key proponent.

Indonesia must shift its economic approach from a predominantly monetary policy to one that is fiscally focussed. Since the 1998 crisis, the monetary approach has created a massive burden on all taxpayers. Currently the government has to spend more than Rp 65 trillion a year to finance bond interest payments. In its 2006 draft budget proposal, the government plans to allocate Rp 73.7 trillion to pay interest on bonds and only Rp 60.3 trillion for foreign debt principal repayments. In the proposal, the government is targeting tax revenue of Rp 534.7 trillion or an increase from Rp 508.9 trillion in 2005. Revenue from income tax will increase from Rp 176 trillion to Rp 198 trillion and value added tax will increase from Rp 102 trillion to Rp 126 trillion. In addition, import duties and levies will increase from Rp 347 trillion to Rp 402 trillion.

The proposed budget shows a deficit of Rp 19.8 trillion (0.7 percent of GDP) and to bridge it, the government will borrow more from domestic and overseas sources. This is likely to trigger further inflation if the government sources are from financial institutions; bank or non-bank ones. Overall, the proposed budget will have a contracting effect on economic development as the government will take from taxpayers rather than inject the money into the economy.

On the monetary side, the central bank is tightening its monetary policy by targeting an inflation zone of 7 percent to 8 percent per annum. It is forecast the central bank's short-term interest rate will stand at from between 8.5 percent and 8.75 percent per annum.

This monetary approach will not be effective in stimulating aggregate demand. It is worth recalling that after the 1998 crisis, our economic growth has mostly been spurred on by domestic consumption.

Fine-tuning our economy with an emphasis on the monetary approach, rather than on fiscal policies, will not be effective in generating desirable economic growth.

The current monetary policy is focussed on tightening the money supply to check the inflation rate at 7 to 8 percent per annum, while the current fiscal policy aims at increasing tax revenues, thereby depressing the purchasing power of taxpayers and consequently cutting into the market demand for goods and services.

Normally, under such conditions, Indonesia should relax its fiscal policy to stimulate aggregate demand. Lowering tax rates would spur aggregate demand and this in turn would stimulate economic growth and development.

But what the government is doing now is imposing a credit crunch through tight money policies and at the same time depressing market demand through heavy tax burdens.

It is most imperative now to prevent monetary policy from depressing aggregate demand, because without a reasonable rate of market demand, the economy will not expand to create new jobs. The government now, more than ever, needs to perform a good balancing act of its monetary and fiscal policies.

It should provide fiscal pump priming for the economy to enhance equality in income distribution and strengthen the rupiah, while corruption should be limited to minimum levels.

Shifting from a heavily monetary-focussed policy to a fiscal one will require a concerted effort. We urgently need to redraw our economic blueprint.

Hendi Kariawan is a former director of Bahana Pembinaan Usaha Indonesia, a securities company.