Fiscal Policy Challenges in Developing Countries: The Indonesian Experience in Responding to the Global Financial Crisis

By Doraisami, Anita | Journal of Southeast Asian Economies, December 2013 | Go to article overview

Fiscal Policy Challenges in Developing Countries: The Indonesian Experience in Responding to the Global Financial Crisis


Doraisami, Anita, Journal of Southeast Asian Economies


I. Introduction

For more than twenty years prior to the Global Financial Crisis (GFC), volatility in aggregate economic activity and inflation fell dramatically throughout most of the industrial world. The widespread and persistent nature of this phenomenon was termed "the great moderation". The most common explanations put forward for this include better monetary policy, structural changes in inventory management, and good luck (see Bernanke 2004; Blanchard and Simon 2000; Summers 2005). The role played by monetary policy led to a consensus that stabilization should continue to be left to monetary policy, with a focus on inflation. Fiscal policy, on the other hand, should rely on automatic stabilizers, with discretionary fiscal policy best avoided.

This consensus which was more prevalent in developed countries was cast aside in the wake of the recent GFC. Both developed and developing countries around the world adopted unprecedented fiscal stimulus packages to mitigate the impact of the crisis. However there was little consensus on what a fiscal stimulus package was expected to achieve. As Hannoun (2009) states, there are two stylized types of policy response: stabilization and stimulation. A measured stabilization policy accepts the fact that adjustment is inescapable and therefore merely aims to mitigate the pain and promote an orderly adjustment. Stimulation, on the other hand, aims to eliminate the adjustment period altogether, and therefore involves a much larger stimulus package.

Blanchard et al. (2008) contend that the optimal fiscal package should be timely, large, lasting, diversified, contingent, collective, and sustainable. It should be timely, because the need for action is immediate; large, because the current and expected decrease in private demand is exceptionally large; lasting, because the downturn will last for some time; diversified, because of the unusual degree of uncertainty associated with any single measure; contingent, because the need to reduce the perceived probability of another "Great Depression" requires a commitment to do more, if needed; collective, since each country that has fiscal space should contribute; and sustainable, so as not to lead to a debt explosion and adverse reactions of financial markets. It is likely that, except for a few countries, this wish list would be mutually exclusive.

There are also contradictory views on the ideal characteristics of optimal fiscal stimulus packages, such as their being timely, temporary, and targeted (Summers 2008) or permanent, pervasive, and predictable (Taylor 2008). Taylor maintains that, based on the permanent income theory or life cycle theory, temporary increases in income will not lead to significant increases in consumption. Further, he argues that an across-the-board approach is far more effective than targeting. Finally, Taylor argues that government policy has been too erratic; it should be as predictable as possible so that individuals and firms know what to expect.

While there are contradictory views on the optimal fiscal stimulus package, there is consensus that expansionary fiscal policy can cushion the impact of an economic downturn in developed countries. However, there is considerable debate about the efficacy of discretionary fiscal policy in developing countries. This paper contributes to the literature by examining the challenges that developing countries confront in employing discretionary fiscal policy by using Indonesia as a case study. The first section provides an overview of the literature on countercyclical fiscal policy in developing countries. Section II of this paper outlines the objectives and composition of the Indonesian fiscal stimulus package. The third section evaluates if the composition of the fiscal stimulus package facilitated the achievement of its objectives. The effectiveness of the impacts of the fiscal stimulus is then assessed examining the actual disbursement of government expenditure and the multiplier effects of the disbursed funds. …

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