The Macro Dimensions of Volatility and Vulnerability: Issues

with reference to the Indonesia Crisis 1998---

Lant PritchettJune 19, 2005

Five Issues of Macroeconomic Crisis

• The relative price of tradable to non-tradable goods

• How is the fiscal adjustment (inclusive of financial sector costs) financed?

• Are real wages flexible?• Are output falls concentrated in

investment?• What is the initial allocation of assets and

exposure to macroeconomic risks?

Illustrated with reference to Indonesia—and potential contrasts Brief chronology, by periodJuly—mid Dec.1997

Thai bhat weakens, contagion to Indonesia, first IMF agreement (16 banks closed, fiscal tightening), rupiah sinks from around 2000 to around 5000

Dec. 1997—May 1998

Soeharto’s health questioned, rupiah sinks again, second IMF package in January, rupiah sinks to 15,000, liquidity provided to Banks, money supply doubles Jan-May, in May Soeharto resigns and Habibie takes over.

May 1998-August 1998

New IMF program in July 1998, provides for “safety net” programs, inflation rapid as CPI doubles, fears of rice shortages, rice price rises rapidly in August

August 1998-June 1999

Money supply brought under control, price inflation stabilizes, safety net programs (particularly sales of subsidized rice) scale up rapidly,

June 1999-- Democratic elections held, lost by Golkar (Soeharto’s party), transition to new government, e-rate stabilized at between 8,000 and 10,000, “crisis” over by January 2000.

Issue One: Relative price of tradables—first Indonesian experience

• Indonesian inflation had always been modest, real and nominal exchange rate quite stable (managed float within bounds)

• The exchange rate depreciated from July 1997 to January 1998 from 2,200 to troughs of 15,000 or lower, “stabilizing” between 10,000-12,000—with little domestic price movement.

• Border prices of importables and exportables sky rocketed

• Rice prices had, for many years, been stabilized (by a logistics agency, BULOG) and trade controlled—but guaranteed a minimum, not maximum price

Indonesian experience: Huge shift in relative price of food

• While CPI inflation was only around 100 percent Feb-August 1998, rice prices and food prices were nearly double the non-food prices

• A great deal of this happened very fast (the price of rice rose rapidly (my recollection is almost 50 percent) in just three weeks in August 1998

• The rise in the price of food had three implications:– Made “macro” measures of poverty irrelevant– Generalized loss in incomes beyond those affected– Made analysis of “losers” complicated

Large shifts in relative prices make “macro” impact measures problematic

• The national accounts data suggested that, although GDP fell 15% most of this was investment (more on this below)

• “Real” consumption expenditures fell by only around 3-5%--hence “poverty” impact appeared small.

• But deflating nominal incomes or consumption by standard price indices was misleading as they reflected a much smaller share of food than the consumption shares of the poor.

• The initial World Bank estimates were wildly off because it assumed constant relative prices or that GDP deflator or CPI were good indices for consumption of poor

Relative price shifts generalized the losses

• The monetization of the fiscal cost increased price levels (more below) and this was compounded by shift in relative price of tradables for the rice consuming poor (more below)

• Those affected by the crisis were not necessarily those with personal shocks (drought, fires, unemployment) but through prices.

Relative price shifts and analysis of the “impact” of crisis

• Initial thought was that a modern sector financial crisis would affect mainly urban and more well to do (some early evidence of this)

• Differential impacts on three groups:– Urban consumers of rice (negative, greater for poorer)– Rural net producers of tradables (positive, greater the

net production, especially of cash crops—”hidup Krismon”)

– Rural net consumers of tradables (negative, but not one for one except for completely landless as “income” from own consumption increased with prices)

Key Questions for relative prices

• Are staple consumption items important tradables?– Could be little or no international trade and domestic

prices do not adjust rapidly to border prices– Could be that food is a small portion of consumption

basket (crises in middle income countries)• To what extent are “poor” net producers of

tradables?– Differentiates rural sector (depends on the extent and

speed with which nominal wages respond to rural profits)

– Urban poor who may lack any production hard hit even with no wage impact

Potential policy implications• Identifying those impacted by the crisis had to move

beyond those affected on the income side.• This is particularly problematic if the exchange rate has

“overshot” the expected future real exchange rate– Do not want to thwart incentive effect by attempting to control

prices– But if RER overshoots because of asset markets and this affects

stables…• Indonesia’s rice subsidy entitled each eligible family to

purchase 20 kgs per month at a stipulated nominal price– “transfer” increased with extent of food price inflation– Created “entitlement” to some amount of food– Could be created rapidly due to existing logistical capability

Second Issue: How is fiscal adjustment financed?

• Particularly acute when a banking/financial sector crisis creates burdens (the cost of banking crisis are often large fractions of GDP)– Revenue increases– Increased debt (to smooth fiscal costs)– Expenditure cuts– Inflation tax

Indonesian experience

• Concern with liquidity of banks and a generalized run led government to lend to banks, this (plus corruption), led to massive expansion in money supply which led to higher prices.

• In absence of indexation, particularly in labor markets, led to massive decline in real wages.

• Real wages fell 50-60 percent—but recovered quite quickly.

Key Question: Who is “vulnerable” in a banking crisis?

• Shareholders in banks?– Almost never happens--“privatize gains, socialize

losses”– Particularly pernicious when losses are looting

• Depositors in banks?– Again, rarely happens?

• Public at large? – Financial system collapse (means of payment,

liquidity freeze up)—perhaps Albania?– Costs of bailing out banks

• Central bank liquidity (impact immediate)• Bonds (impact delayed)

Potential policy implications

• Makes targeting those “affected” difficult as depends on transmission mechanisms of inflation

• Fiscal pressures make availability of resources for mitigation of macro crisis even more problematic (all safety net programs a fraction of just the interest cost of a large banking crisis)

• Lessons from Argentina’s collapse?

Issue 3: What is flexible in the labor market?

• “Fix price” versus “flex-price” assumptions about labor market clearing make a big difference in analyzing labor market implications of macroeconomic downturn

• With “flex price” markets where real wages are not sticky downwards one would expect adjust to come with real wages, not unemployment—market clears period by period

• With “fix price” labor markets then unemployment “clears” the market

• All economies have segments of the labor market with both features—”informal” markets with no regulation, tenure security and “formal” markets with regulation (benefits) and firing restrictions

Indonesian experience• Classic “flex price” adjustment to shock• Real wages fell by nearly 60 percent in six months, then recovered

as nominal wages responded to inflation with a lag—to roughly 5-10 percent fall after a year

• “Unemployment” rose by at most a few percentage points (no benefits, labor market restrictions)

• The monetization of the costs of the crisis plus flexible labor markets led a crisis that began in the urban formal sector to have generalized impacts via level of real wages as nominal wages adjusted with a lag to absolute (and relative price shifts)

• “labor creation” schemes in Indonesia did reach the shocked more often than “the poor”—but could not be scaled up swiftly enough and on a broad enough scale to affect aggregate wages.

Policy responses

• “labor creation” schemes in Indonesia did reach the shocked more often than “the poor”– but could not be scaled up swiftly enough and

on a broad enough scale to affect aggregate wages

– Could not be sustained on a sufficient scale institutionally for more than a very short period

Who is “vulnerable” to labor market shocks in a macroeconomic

downturn?

• “fix price”--the newly unemployed have a large shock to their income while others have small shock—suggests targeting “shocked”

• “flex price”—(nearly) everyone’s real wages are affected (often quite rapidly)

• In a mixture economy some are protected, some bear income and price shocks, some affected via labor markets with continued employment

Potential policy implications• “Unemployment” benefits will protect only the

segment of the population affected via quantity restrictions

• “workfare” programs have their impact via both those employed and affected the equilibrium real wage by augmenting labor demand and perhaps placing a floor on real wages

• …but large and truly open-ended (available to all eligible) is difficult to create quickly in a crisis (possible exception of Chile in 1980s?)

Issue Four: Investment, consumption, smoothing

• A fall in aggregate GDP can come mostly through falls in investment, with little change in consumption—as people smooth by all types of “coping” mechanisms

• Extent and efficacy of smoothing will depend on:– How “temporary” is the shock?– How idiosyncratic (non-covariate) is the shock?– How liquid are available assets?

• Large unexpected shifts in asset prices (exchange rates, real interest rates) cause windfall gains as well as losses

Indonesian experience• There are HUGE issues with panels (measurement error is

LARGE) but existing evidence suggests that during large macro crisis:– Running down of assets was coming as a coping

mechanism– “social” mechanisms did not seem too important– Measured “churning” in the income distribution was

large—even in a crisis there were winners as well as losers

– The dire predictions as the crisis worsened were not borne out—perhaps due to programs, more likely resilience and resourcefulness, there were not the permanent impacts feared

Potential policy implications

• Temporary macroeconomic crisis with universal impacts (impacts via inflation, real wage falls) of modest magnitude

• Temporary localized real sector crisis (drought, terms of trade shock, flood) with large shocks on affected households then targeted response possible (smoothing impossible)

• Permanent macroeconomic shock—what role for “smoothing mechanisms?

Summary: Policy implications of vulnerability due

to macroeconomic factors

• Typology of economy:– Are staple crops of the poor a tradable?– How does the labor market adjust?– What are potential modes of fiscal adjustment

to crisis (at debt limits? Scope for inflation tax? Revenues or expenditures adjustable?)

– Participation of “vulnerable” groups in the “modern” economy and available smoothing mechanisms

Summary: Policy implications of vulnerability due

to macroeconomic factors

• Typology of shock and its propagation– “real” shock (drought, terms of trade) or “financial” or

“macroeconomic” shock (banking crisis, debt crisis)– Permanent or temporary—is output expected to

recover to trend or is this is a shift in trend and/or level of income

– Limited spatially within a country? Will the shock be propagated (at what speed) via linkages (prices, labor markets) that make the shock universal even if limited sectorally in its origins

Indonesia’s experience with macroeconomic crisis and safety net response

• Crisis appeared limited geographically (modern urban sector, drought, fires)

• Inflation (with no indexation) and flexible wages (in real terms) and hyper-depreciation led to rapid universalization of the impact of the crisis.

• Impact on “the poor” was via relative prices, not incomes.

• Only program that reached large scale and scope was subsidized rice

• Targeting was impossible as no “real time” data were (or could be) available.

• “Workfare” might have worked, but did not.

But Indonesia is just what I happen to know…

• If the stable is not a tradable, or is not so important (perhaps Africa)

• If the labor markets are not real wage flexible so concentrated high unemployment persists (perhaps East/Southern Europe)

• If the crisis is permanent, not temporary (perhaps Africa, parts of EE/FSU, parts of Latin America)

• If indexation implies monetization is not possible (perhaps Latin America)