Some lessons from the economic crisis

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.