Some lessons from the economic crisis

Arya B. Gaduh Economist Centre for Strategic and International Studies (CSIS) Jakarta abgaduh@csis.or.id

With the crisis officially over at the conclusion of the IMF program last year, it is time to reflect on lessons learned from it about economic policymaking. Here they are, in an easy-to- remember list of five.

oCredibility: Easy to lose, hard to recover. Among any government's most precious assets to attract investment is its policymaking credibility. Yet, at the onset of the crisis when we needed it the most, this credibility was the first thing to go.

President Soeharto reneged on his reform commitments early in the crisis. Pushed to reform banks and sectors affiliated to his friends and family, he reportedly said that he would "wage a guerrilla war against the IMF." As "the war" raged, its first casualty was investor confidence, followed closely by Indonesia's financial system.

We still feel the impact of this war, as most of the capital that fled has not returned. But more importantly, the government's credibility has not fully recovered. So, in less than half a year, credibility was lost, yet six years later, its harmful effects have lingered on.

Have politicians learnt this crucial lesson? Apparently, but only partially. While calls to renege on international contracts, once a favorite among politicians, have subsided, we continue to see the government failing to honor its contracts. The recent Cemex case suggests that politicians still need reminding of the importance of credibility.

oFirst things first. What accounted for the failure of the early IMF reform packages? A recent independent evaluation of the IMF suggested lack of focus as a culprit. By wanting to reform too much, the packages ended up achieving too little. Worse still, they ended up ignoring some of the crucial core reforms at the macro level.

For a reform package to be successful, political economy dictates that it has to have the necessary political support at critical decision points. Yet, structural reforms, like the ones in the January 1998 reform package, tended to alienate politically connected vested interests.

There is, then, a trade-off between the number of structural reforms and the level of political support they might gain. As the number increased, there was a higher likelihood of sabotage by vested interests. Without unreserved power, the inclusion of too many structural reforms is a guarantee of failure -- and failure undermines the policymaker's credibility.

Since unreserved power does not exist anymore in Indonesia, how should one push for reform? Prioritize: Bundle a few core reforms into one package and implement it well. As success breeds credibility and support, a policymaker can gradually move toward a more ambitious package. In this sense, the narrow focus of the post IMF-Program White Paper on building growth-sustaining institutions is indeed commendable.

oIn a democracy, stakeholders matter. Not all policies require stakeholder consultations, but for some, they are indispensable. Most macroeconomic policies require minimal consultations, while micro-level policies require extensive ones.

Stakeholder consultations minimize the frictions that can hamper their smooth implementation. They not only improve ownership but also help identify groups that stand to lose and therefore plan for the necessary compensations. While they tend to be long and slow, consultations have increasingly become an indispensable policymaking ingredient in a more democratic Indonesia.

This is especially true for unpopular measures. For instance, the absence of a well-designed compensation mechanism (and communications strategy -- see below) has continually allowed vested interests to portray the fuel subsidy removal as an anti- poor policy. Intense prior consultations, combined with a better public communications strategy, might have mitigated such an outcome.

o A communications strategy is key. As previously mentioned, for reform to succeed, it needs political support. When coercion is not an acceptable means of persuasion, an effective communications strategy is the only way to garner that support.

Full transparency is not always the best communications strategy. However, to be effective, the message must be delivered by a credible communicator -- and opaqueness reduces credibility. Indeed, among the things that reduced the IMF's effectiveness in restoring market confidence in 1997 was its policy (which was later revoked) not to publish the letters of intent. Therefore, as a general rule, greater transparency is usually better.

On this, the central government seems have learned more quickly than regional governments. Even in Jakarta, the local government disregards these last two lessons. The governor still makes policies "the old way": Top down, without fully explaining their rationale to the public and stakeholders. Recent transportation and waste management policies serve to prove this point.

o People respond to incentives. This lesson is at the heart of modern economics, yet somehow policymakers tend to disregard it. And when they do, very bad policies are formulated.

The Lippo Bank debacle of early 2003 is an example. Why did it happen? Apparently, the government had agreed to allow the old owner to maintain a majority stake in the bank's management in return for injecting fresh funds into the bank back in 1998. At the same time, the old owner was not barred from buying back the bank.

Under such circumstances, the management had little incentive to maximize the bank's market value -- especially if its old owner really wanted it back cheaply. Hence, it is no surprise few investors were willing to bid a high price for the bank. The loss to the government from the mistake in its bank restructuring approach was huge: For Lippo alone, the recapitalization cost was about 7.7 times the revenue had its upcoming sale been successful.

In crises, policies are often made in an ad hoc way to respond quickly to changing environments. Bank restructuring shows how very costly this can be when policymakers fail to notice the importance of incentive design.