Market confidence – really?

Many governments of both rich and poor countries worry a great deal about ‘market confidence’ and use that as a rationale (at least in terms of public statements) for guiding the design and conduct of macroeconomic policy as well as structural reforms. Inflation nudging above the 5 per cent mark that we set as our target? We better do something about it because the ‘market’ will get annoyed. Debt to GDP ratio inching above 60 per cent? Well, we should start a process  of fiscal consolidation soon or else we might lose our favourable credit rating that has been bestowed on us by the omnipresent ‘market’ (which often appears to be a synonym for credit rating agencies). We need to have flexible labour markets through structural reforms because the market complains about our rigid labour laws which act as a disincentive to invest.

There is insufficient reflection in public discourse on what ‘market confidence’ really means. Are we talking about domestic or foreign investors? Why should be only talk about the ‘confidence’ of the ‘market’ rather than the community at large?  After all, the ‘market’ is embedded in a community and polity. Why discuss a part of it and not the whole? In any case, what is the evidence about the determinants of ‘market confidence’?

One can easily overlook the fact that multiple studies show that formal assessments of sovereign credit worthiness by credit rating agencies routinely include growth indicators in addition to measures of debts and deficits (see, for example, Iyanatul Islam and Martina Hengge,  What is perhaps less well-known is that growth has a more significant impact on sovereign default risks than debts and deficits. The implication is that cutting deficits to reduce public debt might be self-defeating given that such actions typically reduce growth raising doubts among ‘bond vigilantes’ about the sustainability of fiscal austerity measures.

Macroeconomic stability revisited

A 2013 World Bank report (‘Jobs’) notes that macroeconomic stability is ‘fundamental’ to growth and development. Similar proclamations can be found in a 2013 IMF report (also on the theme of jobs) and a 2014 report by the OECD. The IMF report defines macroeconomic stability in terms of low and stable inflation, fiscal and external sustainability. These ideas are core elements of a target-driven approach to macroeconomic policy. Thus, one observes the rise and entrenchment of the notion of inflation targeting and fiscal rules.

As is well-known, inflation targeting was first introduced in New Zealand in 1990 and subsequently this became the norm for OECD countries. Developing countries also adopted inflation targeting – or least had publicly announced inflation targets. For developed countries, the typical inflation target ranged between 2 to 3 per cent and for developing countries, the upper limit for inflation was typically set at 5 per cent.

Fiscal rules – in which publicly announced limits were placed on budgetary aggregates – also became part of the toolkit of developed countries and subsequently were adopted by a range of low and middle-income countries. The Maastricht Treaty, for example, set 3 per cent budget deficit (relative to GDP) and 60 per cent public debt to GDP ratio as part of its fiscal framework. Similar numbers can now be found for such large and populous economies as India and Indonesia. A 2015 OECD Policy Brief has issued new guidelines suggesting that emerging economies should aim for 30 to 50 per cent debt to GDP ratio.

The IMF has spent a good deal of its intellectual and operational resources to suggest some targets with respect to external sustainability. A conventional prescription is that developing countries should have adequate foreign exchange reserves that have at least three months of import coverage.

Based on these ideas one can now formulate an operational notion of macroeconomic stability. Thus, macroeconomic stability for developing countries prevails if: (1) the publicly announced inflation target  is not persistently breached, (2) the publicly announced fiscal rules are, on average, met  and (3) there are adequate foreign exchange reserves.

How robust are the macroeconomic policy targets as noted above, especially as perceived from a development and growth perspective? This is where critics would argue that the notion of macroeconomic stability becomes fuzzy. Can one really say with a great deal of confidence that a developing country that, say, has an inflation rate of 7 per cent is likely to grow less rapidly than a developing country that persistently meets an inflation target of 4 per cent? Unfortunately, the relationship between growth and inflation is not robust. Similar caveats apply to the relationship between growth and fiscal rules. Of course, one can readily agree that hyper-inflation is bad for growth as are out-of-control budget deficits. Outside these extremes, ‘intermediate cases’ are more complicated and clear-cut pronouncements are not easy to make. Hence, discretion and judgement, informed by the best available evidence, is a desirable way of conducting macroeconomic policy rather than an uncritical embrace of a target-driven approach to macroeconomic stability.

I explore these ideas more fully in one of my recent co-authored books: Islam, R and Islam, I (2015) Employment and Inclusive Development, Routledge, London and New York.