An economist is "someone who sees somethinghappen and wonders whether it would work in theory,"as Ronald Reagan used to say. The old quip containsa lot of truth. Indeed, economists' obsessive pursuit oftheory has led them into a cul-de-sac, detached from reality.
What's absent from today's economic discourse is the conceptof consumer and investor confidence in a nation's government andeconomy. This wasn't always the case. As the Cambridge donJohn Maynard Keynes put it: "The state of confidence, as theyterm it, is a matter to which practical men pay the closest and most anxious attention." Another Cambridge economist of his era,Frederick Lavington, identified confidence as a key component ofthe business cycle. His 1922 book, The Trade Cycle, described the"tendency for confidence to pass into errors of optimism or pessimism,"which triggers booms and busts.
By ignoring the confidence factor, economic theory can leadto wildly incorrect conclusions and misguided policies. Just consider naïve Keynesian fiscal theory—the type presented in textbooks and embraced by most policymakers and the general public. According to Keynesian theory, an expansionary fiscal policy (an increase in government spending and/or a decrease in taxes)stimulates the economy, at least for a year or two after the fiscalstimulus. To put the brakes on the economy, Keynesians counsela fiscal contraction.
A positive fiscal multiplier is the keystone for Keynesian fiscaltheory because it is through the multiplier that changes in thebudget balance are transmitted to the economy. With a positivemultiplier, there is a positive relationship between changes inthe fiscal balance and economic growth: larger deficits stimulategrowth and smaller ones slow things down.
So much for theory. What about the real world? Suppose acountry has a very large budget deficit. As a result, market participants might be worried that a further loosening of fiscal conditions would result in more inflation, higher risk premiums andmuch higher interest rates. In such a situation, the fiscal multipliers may be negative. Fiscal expansion would then dampen economic activity and a fiscal contraction would increase economicactivity. These results would be just the opposite of those predictedby naïve Keynesian fiscal theory.
The possibility of a negative fiscal multiplier rests on the centralrole played by confidence and expectations about the courseof future policy. If, for example, a country with a very large budgetdeficit and high level of debt makes a credible commitment to significantlyreduce the deficit, a confidence shock will ensue and theeconomy will boom, as inflation expectations, risk premiums andlong-term interest rates decline.
There have been many cases in which negative fiscal multipliershave been observed. The Irish stabilization of 1987-89 isnotable. The fiscal deficits that preceded the Irish fiscal squeezewere clearly unsustainable, and risk premiums and interest rateswere extremely high. A confidence shock accompanied a tighteningof fiscal policy, and with negative multipliers in play, theIrish economy took off. Building on this first burst of confidenceand growth, Ireland introduced a host of free-market reforms andhas become the so-called Irish Tiger. To accommodate its highgrowth, Ireland, a traditional exporter of labor, has become a laborimporter.
Margaret Thatcher also made a dash for confidence and growthvia a fiscal squeeze. To restart the economy in 1981, Thatcher instituteda fierce attack on the British deficit, coupled with an expansionarymonetary policy. Her moves were immediately condemnedby 364 distinguished economists. In a letter to The Times,they wrote a knee-jerk Keynesian response: "Present policies willdeepen the depression, erode the industrial base of our economyand threaten its social and political stability." Thatcher was quicklyvindicated. No sooner had the 364 affixed their signatures thanthe economy boomed. People had confidence in Britain again,and Thatcher was able to introduce a long series of deep free-marketreforms.
This brings us to the Philippines. President Arroyo came topower in 2001. She had inherited a fiscal mess, the type that isaccompanied by negative multipliers. Fiscal consolidation quicklybecame the order of the day, with the consolidated budget deficitfalling from 5.3% of GDP in 2002 to a projected 1% this year. Asin the Irish and British cases, a confidence shock and a boom haveresulted from Arroyo's fiscal squeeze.
Will the Philippine boom continue? Not without furtherdeep economic reform. At a fundamental level, the Philippineeconomy is dysfunctional and doesn't produce enough jobs. Thatexplains why it dumps (exports) such a huge portion of its surpluslabor force. According to the Commission on Filipinos Overseas,over eight million Filipinos are working in foreign countries. Thatamounts to 21% of the Philippine labor force, and in 2006 theysent home $24.7 billion, 56% of Philippine exports.
As further evidence of the long reform road ahead for PresidentArroyo, consider the results of the World Bank's most recentEase of Doing Business 2008 (see table). Of the 178 countries included,the Philippines has very poor rankings. Even more troublingis the fact that its rankings have not improved during thepast year. If anything, they have deteriorated.
If President Arroyo fails to capitalize on her positive fiscal confidenceshock with a credible set of structural reforms, the Philippineswill continue to be one of the world's biggest labor dumpersand its economy will remain vulnerable.