SOURCE: MILLENNIUM CHALLENGE CORPORATIONHTTPS://WWW.MCC.GOV/RESOURCES/STORY/STORY-CDG-CHAPTER-3-GUIDELINES-FOR-CONSTRAINTS-TO-ECONOMIC-GROWTH-ANALYSIS
On Aug. 4, the Philippine Statistics Authority (PSA) announced that Philippine inflation hit 6.4% in July, the fastest year-on-year growth in four years.
Fast-rising inflation has exacerbated poverty and affected household spending all over the country. But at the same time, this inflation is not a result of a “hot economy.” In fact, we are still at the critical stage of recovering our economy and returning to pre-pandemic levels of income and output.
In short, the administration needs a solid, coherent plan. The goal is not just to arrest immediate inflation and mitigate its negative impact, but to bring about sustained economic growth in the Philippines following the pandemic-induced recession and a high fiscal deficit.
In this regard, a central question that Ferdinand Marcos, Jr.’s state of the nation address (SONA) should have answered is: What is the President’s diagnosis of the main problems plaguing our country? What are the binding constraints on the economy? And how did he arrive at the diagnosis?
In his SONA, the President said that we face “difficult times.” and “we will continue to find solutions.” With respect to the economy, he enumerated a number of proposed measures wherein he highlighted “sound fiscal management.” But clarity is lacking as to what underpins these proposals, and whether these proposals are most responsive to the binding constraints.
Instead of assessing the country’s current economic situation and the policy recommendations, this piece (Part 1) will focus on explaining how to do the growth diagnostics approach. This policy tool comes from a 2005 paper by Ricardo Hausmann, Dani Rodrik, and Andres Velasco, entitled “Growth Diagnostics.”
The paper informs readers, particularly policy makers and economists, on the relevance of doing diagnostics to identify an economy’s binding constraints. It is likewise a critique of the Washington Consensus (WC), a set of wholesale, if not second-best, policy recommendations supported by the International Monetary Fund and the World Bank. The WC failed to deliver sustained higher levels of investments in many emerging economies.
Hausmann et al. argue that a growth diagnostics approach is needed towards narrowing the policy interventions that are most appropriate to removing the major barriers to investments. Setting the ambitious goal to solve all problems or distortions all at once (like the WC) is unrealistic. The arguments of Hausmann et al. are summarized below.
There are four typical reform strategies, which Hausmann et al. argue are inferior to the growth diagnostics approach.
The first is “wholesale reform,” in which all issues are simultaneously eliminated. This is practically impossible. In the first place, policymakers lack the relevant information regarding all the distortions in order to do wholesale reform. In the second place, pursuing reforms everywhere stretches and exhausts institutional capacity.
The second is “do as much reform as you can, as best as you can,” which is the prevailing approach and is a laundry-list approach to reform. This simply goes for whichever reforms seem to be doable, relying on the idea that the more areas are reformed, the better, and that any reform is good. This is faulty because we cannot be sure that any given reform taken on its own can be guaranteed to be good, due to numerous other issues which it might interact with. For example, a doctor can prescribe medicine that is in itself good for the patient, but when taken in combination with other drugs, it could have contraindications and lead to increased harm.
The third is the second-best reform, which prioritizes reforms that lead to positive second-best effects. But it is often difficult to forecast second-best interactions before they happen. Despite being aware of possible negative effects of the interaction of doable reforms, we cannot at the outset predict what the costs are. The full transaction costs of a controversial reform, for example, only emerge after the fact.
The fourth criticized strategy is: If the second-best interactions cannot be ascertained, reformers may opt to target the biggest distortion. But this doesn’t guarantee that the reforms with the biggest impact on economic welfare and growth will be worked on first. Biggest distortions do not necessarily correspond to achieving the biggest net benefits for society. (Take for example, the higher corporate income tax, relative to similarly situated countries in the region. One can concede that this is a big distortion. But investors themselves do not consider the higher tax as the most binding constraint.)
We cannot thus afford to undertake what Hausmann et al. call a “spray-gun” approach, which has too many targets. As worldwide experience has shown, it is not only ineffective; it also leads to unintended adverse consequences, making the situation worse.
Besides political, capital, time, and resources are finite. Hence these limited resources are better used to work toward the most important reforms.
The solution is to focus on the most binding constraints, or the principal problems, which provide the most “bang for the reform buck.” This approach focuses on the bottlenecks directly. These are the obstacles that if not cleared, would make the economy grind to a halt. Overcoming these obstacles brings about a large magnitude of benefits for society, the economy, or the sector.
Determining binding constraints is not a simple task. The growth diagnostics approach uses a problem tree (Figure) to look at the proximate determinants of economic growth (e.g., savings, innovation, infrastructure, etc.) rather than the specific problems.
Using the problem tree requires answering the following questions: What keeps growth low? What hinders the flow of productive investments? Is the main problem the low return to economic activities or the high cost of finance?
If the main problem revolves around low return to economic activities, is it due to risks in the macroeconomy like inflation or narrow fiscal space? Or is it about low social returns like insufficient investment in complementary factors of production such as human capital or infrastructure? Or is it due to poor access to technology? Or poor property rights and contract enforcement, labor-capital conflicts, or learning and coordination externalities?
Or is low growth mainly explained by inadequate access to finance? Are there problems with the domestic financial markets or external markets? If it’s a problem of poor domestic markets, is this due to fiscal deficits or poor intermediation?
After doing a process of elimination, we can separate the non-binding from the binding constraints. Once we know where to focus, we find the associated economic distortions whose removal will make the biggest contribution to alleviating the constraints on growth. Then we can proceed to choosing the appropriate policy or intervention. However, this does not yet determine the exact sequencing of policy interventions. Once the primary binding constraint is adequately addressed, we return to the problem tree framework for the next challenge.
To illustrate the use of the growth diagnostics framework, let’s apply this to the case of the Philippines. In 2010, when President Noynoy Aquino’s term began, the binding constraint was the narrow fiscal space due to the previous administration’s politicized spending and reluctance to pass further tax reforms. To resolve this, the Aquino administration successfully pushed for the passage of the sin tax reforms, which increased, simplified, and improved the excise tax regime.
The sin tax reforms relaxed our fiscal space. However, it was still necessary to further increase taxes to finance high spending for infrastructure. During the Aquino term, infrastructure spending was low and became a binding constraint.
The Duterte administration addressed the issue of low infrastructure spending, inadequacy, and deterioration of infrastructure by legislating the comprehensive tax reform program. This resulted in the country’s highest tax effort since the Ramos administration. These reforms upgraded our creditworthiness and enabled the financing of infrastructure and other public goods.
Moving forward, we ask: What are the binding constraints hampering growth in the Philippines today? A wholesale reform strategy will only waste our resources. In the same vein, a misdiagnosis can possibly further constrain our growth. Is the binding constraint the “high cost of finance” or the country’s rising debt? Is it low social returns, arising from the COVID-19 pandemic? Is the health system or the education system impeding growth and investments? Does infrastructure remain a binding constraint? Or have the macro risks like the threat of narrowing fiscal space and high prices emerged as a binding constraint?
The challenge thus is to define a narrow target of policy interventions that are responsive to removing the most binding constraints.
The next piece will focus on Marcos Jr.’s economic policy priorities and the policies needed to address the binding constraints.
(To be continued.)
The authors belong to Action for Economic Reforms.