Shifting from monetary to fiscal policy

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.