Pa‘anga in trouble [1]
Sunday, March 30, 2003 - 10:44. Updated on Friday, February 19, 2016 - 15:42.
From Matangi Tonga Magazine Vol. 18, no. 1, March 2003.
By Peter Poulsen.
There is increasing interest in the state of the economy: in particular the fall in the level of the Pa‘anga, the high level of inflation, and the economic reform programme. I intend to link these issues and to explain the economic and developmental factors behind them. In an educated, open society like Tonga’s, it is important that as many people as possible understand these important issues so that they can make informed contributions to the debate.
The Role of Governments
Since Government is one of the main players in the economy and has a disproportionate influence on the status of the economy, it is useful to start with the role of Government. The size and extent of services provided by governments differs among countries, and over time in the same country. A brief historical review of changing attitudes as to the role of government will help us to put the current reform programmes in Tonga into a wider perspective.
The Classical Economists argued that the market was able to look after itself and that there should be limited government intervention. Following the social devastation of the Great Depression of the 1930s this attitude changed. Followers of Marx in communist countries were already eliminating private property and the government was taking over all aspects of the economy through central planning. Others like Keynes, still saw a role for an active market economy, but with considerably greater participation by government in controlling the overall level of economic activity.
During and following WWII government control of market economies expanded considerably, and a range of industries was nationalized in many countries. The rise of the welfare state also resulted in significant expansion in the role of government in the social sphere.
US aid, such as the Marshal Plan, contributed to the recovery of the war torn economies in Western Europe and Japan. Given the success of this aid, the focus of assistance was moved to the newly independent developing world. The assistance was channeled between governments and was unfortunately used as much for political as for development reasons. This growth in aid strengthened the role of governments in both donor and recipient countries. Governments in developing countries also tended to enter into detailed planning and control of their new economies as this was seen as a way of quickly boosting their development.
System failure
By the mid-1970’s much of the structure of the post-war world was coming under increased pressure. Government control of the economy was becoming less successful as first the fixed exchange rate system failed, and then both inflation and unemployment became simultaneous problems that did not respond to government intervention. Concern was also expressed about the welfare mentality that was constraining performance and growth. The ability of public servants to manage successfully large businesses under increasingly sophisticated economic conditions also came under question.
Finally the collapse of the Soviet Union showed the extent to which central planning had failed there. China avoided this collapse by introducing major market reforms and privatization, which resulted in significant growth in output, despite government maintaining control of large parts of the economy.
In the West, the Keynesian view was challenged by the rise in alternative theories such as Monetarism: Government’s role in the economy was considerably curtailed, government run business were privatized, the emphasis was on improved performance. The market was seen as far more efficient than government lead planning. Markets have been opened up to increased international trade (though many barriers still exist) and we have seen the rise of what has been called ‘globalization’.
This change in perspective has also impacted on the delivery of aid. Much of the aid given to government was seen as wasted, especially when political considerations dominated. Aid is now increasingly being focused on encouraging private sector development, reforming and streamlining governments, and promoting non-government organizations.
While significant progress has been made in economic efficiency and growth as a result of these policies, concern is now being expressed that too much emphasis is being placed on development of business and profits, that trade unions have suffered, many have not benefited from the increased growth, the environment is being sacrificed, etc. The pendulum is beginning to swing back towards greater government involvement.
Debate
There is no final answer in this debate. History has shown that swings continue back and forward: when governments dominate, the solution to current problems is seen in cutting the size of government and increasing the role of the private sector; conversely, when the private sector dominates, problems that arise suggest the need to control the private sector and increase the influence of government. While economists have much to say on this debate, the final choice made at any time is essentially a political decision.
An interesting aspect of the current phase in the debate is the focus on a wider degree of participation: non-government groups based around a wide number of interests are questioning both the role of governments and big business. Some opposing groups rally round an “anti-globalization agenda” and emphasise the need for greater focus on local needs.
This evolving debate will again change the ways in which societies make decisions and solve such questions as: how a society should be governed, who should control decisions on what is produced and for whom, the trade off between protecting the environment and using non-renewable resources. These are all issues that are increasingly been formulated within the framework of the long-term sustainability of our development both as individual countries and as a whole world.
The Government Budget
Whatever the role of government, a government needs to raise revenue to finance those services and activities that it is expected to undertake. Governments produce budgets to detail how this revenue is raised and how it will be spent. If, collectively, we place demands on government to spend more than we are willing to pay in revenue, there are only three ways that government can fund this excess expenditure: running down government deposits, borrowing, or printing money.
Deposits can only be rundown until they are depleted, and loans have to be repaid. Printing money is the same as ‘taxing’ those people who are holding cash or bank deposits in pa‘anga, since printing money tends to lead to inflation, which cuts the value of pa‘anga held by people. Thus, over time Governments can only spend as much as they collect, including the ‘inflation tax’.
Borrowing
Borrowing is a valid way of funding productive investment: those which will generate more income than the cost of repaying the loan and the interest. Governments can borrow directly from local or overseas banks or issue bonds that may be purchased by banks, other organizations and individuals. However, government must be careful about borrowing too much domestically, as this may make it more difficult for local business to borrow and thus restrict their ability to expand their activities.
If governments borrow too much, the future payments of interest and principal become so large that government has to cut expenditure on services and capital investments. In the worst case, a country may not be able to continue to make these repayments and may effectively default. This has in effect happened to a number of the heavily indebted countries. The ultimate solution is a mix of severe expenditure cuts, increased fees and taxes, and rescheduling of debt, or out right debt forgiveness. These actions can have disruptive effects, make it much more difficult to borrow for productive investments in the future. This is a dangerous position to get into – just see the recent upheavals in Argentina!
Effect of Printing Money on Inflation and Foreign Reserves
When Governments issue bonds, they often sell them to the Reserve Bank, who then sells them on to the private sector for Government. If the Reserve Bank cannot find others willing to buy the bonds, the Bank has to print money when these bonds are issued, thus creating new cash. Government spends this cash, in competition with the rest of society. As this is new cash, it was not earned from producing something, so these purchases will tend to push up local prices, which leads to inflation.
In small open economies, like Tonga, much of this expenditure will go on imports. To pay for these imports we will have to use up our foreign exchange reserves (these are the total value of foreign currency held, mostly, by the Reserve Bank), since we can not use our Pa‘anga to pay for foreign goods. If we hold large amounts of foreign exchange reserves this is not, initially, a problem, but sooner or later we will reach a level where it will become difficult to finance further imports. This can be very disruptive to our economy and welfare.
Fall in value
When foreign exchange reserves are falling a country’s currency may fall in value. If the exchange rate is determined by the market, which is called a floating exchange rate, this fall in value is called depreciation. In Tonga, the rate is set by the Reserve Bank based on a basket of currencies from our main trading partners. The Reserve Bank may decide to decrease the value of the Pa‘anga, i.e. devalue it, to try and cut the level of imports and boosting exports.
Depreciation, or devaluation, will increase the Pa‘anga price of both imports and exports relative to local wages and the price of goods produced in Tonga. This change in relative prices may encourage people to consume less imports and more domestic goods, and maybe try and export more rather than sell produce locally. These increases in prices, however, will also contribute to inflation. Prices of locally produced goods will tend to rise and employees will push for wage increases—as recently happened with the 20 per cent cost of living adjustment for public servants.
Savings loss
The inflation will cut the value of any cash people hold, and if interest rates fail to rise, people will also loose, as their savings can buy fewer goods. Until they are able to get their incomes increased, it cuts the amount they are able to purchase. It is this fall in spending power that helps to slow the fall in reserves.
To restate: the government is only able to increase its expenditure and purchase of items because of the fall in foreign reserves, and the cut in the public’s spending power. Once wages and all prices have adjusted, the effect of the devaluation will be removed because prices will have all gone up by more or less the same amount, and we will be back to the same relative prices we started with; so there will no longer be the incentive for consumers to import less and for producers to try and export more. However, if government goes on printing money the reserves will continue to fall, more devaluations will be made and we will have more inflation.
People suffer
There are several other undesirable consequences of this inflation and devaluation. It is often the weaker members of society who suffer most from inflation, e.g. pensioners, those in unskilled jobs without the ability to push for wage increases. Inflation also distorts the way the market works making it more difficult to compare prices; this results in wastage of resources as people make less well informed economic decisions. Continuing devaluation results in loss of confidence in the Pa‘anga so more people will hold their export earnings and savings overseas; this will in turn cause our foreign exchange reserves to be even lower that they would have been. This is already the case with many businesses in Tonga.
Government bonds
Thus the inflation and devaluations that we are experiencing are largely due to government trying to fund the budget by having the Reserve Bank print extra money to buy government bonds. The devaluation cannot solve the problem it is only part of the inflationary adjustment. The only way to control the inflation and stop devaluations is to stop printing money. This can be accomplished in two ways: control expenditure and/or increase revenue collection. So we are back to the need as a society to decide how much revenue we wish to pay government in return for the levels of goods and services provided by government. It is when we have gotten into the situation where such adjustments are essential that governments are often forced to undertake a programme of reform.
Adjustment in Tonga through Reform
Government in Tonga has recognized these problems and has commenced a programme of reform with the goals of “improving the efficiency of the Government” and creating “an environment more conducive to economic development and growth”.1 The objectives are common to current reform programmes all over the world, and include: improved performance of the public service; enhanced and sustainable fiscal conditions; improved service delivery to the private sector and encourage development of business for private sector lead growth; and mitigating the negative impacts of these reforms.
Teams have been established to address reforms in five areas: fiscal; public service; financial sector; private sector; and economic and social impact monitoring and mitigation. Many activities are listed for these teams, a few include: improving management of the budget information and procedures to encourage more sustainable budgets; control debt financing; encourage a performance-oriented culture in the public service; cut staff costs as share of the budget; review legislation to facilitate operations of the private sector; encourage privatization; and establish better data for monitoring the social and economic impact of the reform programme.
Based on the limited information I have from the pamphlet on Basic Information for the reform, this looks like a comprehensive coverage of issues. If followed through, it should address the issue of government borrowing from the Reserve Bank and the resulting devaluations and inflation; as well as many of the other areas needing change.
Assistance
There is a wealth of experience to draw on from other countries, and several of our donors are funding technical assistance to help with this process. However, such assistance is not enough. Experience from elsewhere shows that for such reforms to really work there must first be strong local commitment and leadership; and secondly, there needs to be broad understanding and option for debate both within government and between government and the wider community on how best to implement the reforms and adjust to unforeseen consequences.
The need for this broader consultation is partly recognized by the publishing of the pamphlet, however, looking at the structure of the five teams, there is only one team that has a non-government participant. This is rather limiting. A programme of reform such as this needs a clear information and consultative mechanism—it must be two way, not just from government. Such a mechanism may be under consideration; the sooner it is developed and shared with the wider community the better. Many governments and public servants are weary about such consultative mechanisms but they are essential to successful reform. No government can accomplish this alone, we must all contribute and play our part —hence good consultation is so important.
Finally, while the programme focuses on economic and administrative reform, it should be clear from the earlier discussion, how such reforms impact on the relative role of government and the private sector. History shows that such changes will thus impact on the social and political arenas—since politics is essentially the means by which members of society use power to negotiate solutions to the difficult trade offs and decisions that must be made. Tonga has shown in the past, through the vision of Tupou I, that the indigenous capacity exists for integrated reform appropriate to the needs of Tongans—ultimately the successful development and evolution of Tonga will depend on our current generation finding appropriate solutions in all spheres—economic, social and political.