Mon, 12 May 2003

Macroeconomic stability? By what definition?

D.A. Simarmata, School of Economics, University of Indonesia, Jakarta,

Macroeconomic stability are some of the most frequent words heard today, either from officials or from those in business. Surprisingly, they add a contradictory term to that: High unemployment. This is a contradiction because the word "macroeconomic" includes the employment rate, which should be at an acceptable level, say 4 percent to 5 percent.

Most governments prioritize employment, the continuity of their government being at stake. Full employment is the dream of all societies, which is usually expressed in their political platforms. But in this country, full employment is easily discarded from the government's priority list, it, without hesitation, triumphantly stating the achievement of macroeconomic stability despite rampant unemployment. Are the academics in the government ignoring the basic definitions of macroeconomics? Is it pleasantry or just intended ignorance?

In referring to a book written by Dornbusch, Fischer and Startz, one finds a series of issues regarding macroeconomics -- the economy as a whole -- covering the topics of gross domestic product (GDP), inflation and unemployment rates, balance of payments, interest rates, exchange rates, current account, and so on.

By aiming for macroeconomic stability, all the macroeconomic variables should lie within an acceptable range of values. The role of employment in any economy is decisive for the determination of GDP.

By following "Okun's law", each 1 percent additional unemployment rate reduces the GDP by 2 percent. Or, stated otherwise, each reduction of 1 percent in unemployment will raise 2 percent of GDP. If the unemployment level is assumed to be 15 percent, then by reducing it to 5 percent, the GDP will rise by 20 percent.

This is a very large amount, in the order of Rp 300 trillion approximately, and would bring in a large amount of income tax for the government. Besides, all economic efforts should be directed to serving human beings. One of the basic needs for human beings is to have a workplace, matching her or his ability. This is a basic human right. So, this should be a matter of utmost importance for any government, including the Indonesian one.

Law no. 23/1999 on the Indonesian central bank assigns Bank Indonesia to maintain the stability of prices. The central bank has interpreted the task in its work program as achieving a low level of inflation.

From a multiple-objective function imperative, the central bank law has reduced it to a narrow, single objective, forgetting the objectives of full employment. This is a very significant drawback in the law, compared even with the frequently cited Bundesbank law, an exemplary independent central bank all over the world. But the Bundesbank is obliged to support the German Federal Government to achieve full employment. This is now done in concert with the European Central Bank (ECB).

The Indonesian central bank is intensively working on the intellectual basis for practical direction of the inflation- targeting instrument. The concept was originally employed in the New Zealand central bank, now in vogue in many countries.

But the instrument has been under attack from many sides. Some economists in India talk about the inappropriateness of the method for them, because the basic concept of core inflation used in the model does not take into account the volatility of the price of food and many other basic necessities. These goods are vital for the lives of the majority of the people.

By neglecting them in monetary management, it is equally neglecting the needs of the people in the country. So what is the purpose of the central bank?

There is also another peculiar thing in law No. 23/1999, in that the central bank is not considered to be part of the government. It is independent, so the central bank has no obligation to support the overall objective of the government, namely to reduce the unemployment rate. What a chaotic concept!

Paul Volcker, the Federal Reserve (Fed) chairman before Alan Greenspan, stated that the central bank was part of the government. The Fed is independent within the government. And, the president of the US has the right to replace the Fed chairman, if he considers it necessary. President Clinton once considered replacing Alan Greenspan, but decided not to do so due to fears of the probable consequences on financial markets.

Greenspan has such high credibility that any attempt to dismiss him could destabilize the market. As a mater of fact, Greenspan is a member of the Republican Party while Clinton is a Democrat.

The limited task of the central bank for maintaining stability in prices should be revised, which means revising Law No. 23/1999. Controlled inflation, which was below 10 percent before 1997, should remind us that low inflation is not a guarantee against financial crisis.

A recent study showed the occurrence of financial crisis amid a stable macroeconomic situation (not in the above Indonesian sense).

Latest data on the Indonesian economy shows that the utilization rate of the installed capacity is 40 percent to 50 percent. On the other side, the lending to deposit ratio (LDR) of banks is approximately at the same level, around 50 percent. Such a high level of idle capacity is a sign of economic depression. Hence, an increase of one percent in GDP does not necessarily require a normal ICOR, say 5 to 5.5.

Industry needs only working capital, which should be much less than if it included new investment. At this state of the economy, the ICOR could lie in the range 2 to 3. But alas, Bank indonesia only concerns itself with the IT concept, and the government is busy with the ICOR concept, arguing about the absolute necessity of new investment. Unfortunately, both proclaim macroeconomic stability, despite high unemployment rates. What a big lie!