Indonesia | Economics

Monday, April 21, 2003

Inward-looking policies tend to create distortions

What we need is to fix to our domestic policy, not our trade policy.

(21 April 2004, Jakarta Post) The prospect of a slowdown in the global economy gives people the jitters. Up until now, such feelings have been fueled by the U.S. incursion in Iraq and the "Guangdong flu". Not for long: With the war practically over, and dwindling anxieties about the flu, the issue of what is next with the Indonesian economy will start moving center stage.The relevant question is: What policies should the government implement to anticipate the possibility of a post-war global economy slowdown?

There are many possible good answers, but "inward-looking policies" should not be one of them.

These refer to policies that strengthen domestic industries by means of introducing distortions, such as industrial subsidies or trade restrictions, to the economy. Hence, the following criticism does not apply, for instance, to initiatives to remove export-orientation bias in order to strengthen domestic-oriented industries. It does, however, apply particularly to recent calls for increased protectionism.

So, what's wrong with inward-looking policies? If trade restrictions or industrial subsidies can strengthen certain domestic sectors, why shouldn't we implement them? There are at least two textbook answers to this question.

First, distortions such as tariff barriers or sectoral subsidies misallocate resources and disable potentially more productive sectors to flourish. A simple example: Fuel subsidies that favor fuel-intensive modern sectors disadvantage traditional sectors (such as agriculture) by encouraging investment in artificially more productive modern sectors -- artificial, because it is subsidized. In other words, when a sector is given preferential treatment, others suffer.

The second problem is that although most distortions are supposed to be temporary, once they are there, removing them is often a Herculean task. Fuel subsidies, for instance, were originally introduced to encourage industrialization and a shift from traditional to modern energy sources in Indonesia.

Once the transition was complete, there was no economic (or social justice) rationale for maintaining them. Yet, the politically influential middle-class and modern industrialists refused to let their long-cherished privilege easily, barring every attempt to remove the fuel subsidies.

However, surely, this argument only applies when distortions favor the big, dirty industrialists. But what about farmers? After all, isn't there a social justice argument for increased protection of the agriculture sector, where most of the poor are employed? The answer to this is, once more, a resounding no.

While an argument can be made for taking measured steps in removing existing distortions in the agriculture sector, none can be found for increasing them.

Removal of protection increases the productivity of a sector and the overall economy; yet it also entails costs for workers from inefficient industries in the sector who are laid off. In agriculture, many are poor farmers might find it difficult to adjust, i.e., find other employment, once they are laid off. Hence, to avoid high social costs, the removal of protection must be done gradually instead of in one shot -- ideally accompanied with measures to minimize the cost of adjustment to poor farmers.

Nevertheless, this does not justify increasing protection just so that people are drawn into the inefficient sectors within agriculture. After all, why double the cost -- first, to the efficiency of the economy, and then, to workers who have to readjust because of this newly introduced distortion?

That is why, recent calls for increased protectionism in response to the pronouncement of a slowing global economy is unproductive. In truth, however, dealing with distortions might not be the most important thing for our economy.

And here is where I think the proponents of inward-looking policies got it wrong. No, we don't need inward-looking policies -- we need "looking-inward" policies.

There is little empirical evidence to support the notion that increased protection (or, for that matter, increasing the minimum wage -- another proposition from the inward-looking policy camp; but that is another matter for another time) is beneficial for our small economy. There is, however, abundant support for the idea that investment matters a lot for growth -- which, hence, motivates the following looking-inward proposal.

Looking inward here means finding ways to maximize investment in Indonesia -- be that foreign or domestic. We are familiar with the general long-term prescriptions: Improve legal certainty with regards to taxation, labor relations and security. We need to add to this list increased transparency, property rights assignments, as well as an effective bankruptcy law. The general idea is to ensure entrepreneurs can reap the full benefit of their investments.

Although oriented toward the long term, it doesn't mean that these policies can be taken for granted. Most urgent for domestic investment is the assignment and protection of property rights, particularly with regards to land rights throughout Indonesia. Hence, real steps must be taken to deal with them. Yet, given our economy's immediate need for recovery, long-term prescriptions need to be complemented with short-term ones.

In the short term, however, the most practical thing to do is to remove existing distortions that turn away investment. Here, I agree with the economist M. Chatib Basri in suggesting the lowering of import tariffs and sales taxes for various input commodities to increase the profitability of domestic industries (Kompas, April 12). That is, instead of increasing protection measures, we need to reduce them.

Moreover, in the short-term to medium-term, the government needs to immediately restore the intermediary function of the financial sector by a measured lowering of the risk-free Bank Indonesia Certificate (SBI) rate, among other measures.

Inward-looking policies are attractive because they appear to be doing something they are not. Looking-inward policies, however, are less attractive, especially because they often go against the interests of the politically connected minority who benefit from protectionism. Yet, if we care about the economy, instead of politics, it is the latter, and not the former, that we really need.

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