Getting the Right Diagnosis – BusinessWorld Online


(Part 1)

On August 4, the Philippine Statistics Authority (PSA) reported that inflation in the Philippines hit 6.4% in July, the fastest year-on-year growth in four years.

Rapidly rising inflation has exacerbated poverty and affected household spending across the country. But at the same time, this inflation is not the result of a “hot economy”. In fact, we are still in the critical stage of recovering our economy and returning to pre-pandemic levels of income and production.

In short, the administration needs a solid and coherent plan. The goal is not only to stop the immediate inflation and mitigate its negative impact, but to bring about sustained economic growth in the Philippines after the pandemic-induced recession and 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 major issues 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 we are going through “difficult times”. and “we will continue to find solutions”. Regarding the economy, he listed a number of proposed measures in which he emphasized “good fiscal management”. But there is a lack of clarity as to what underlies these proposals and whether these proposals best meet the binding constraints.

Instead of assessing the country’s current economic situation and policy recommendations, this article (Part 1) will focus on explaining the growth diagnostic method. This political tool comes from a 2005 article by Ricardo Hausmann, Dani Rodrik and Andres Velasco, titled “Growth Diagnostics”.

The article informs readers, in particular policy makers and economists, about the relevance of making diagnoses to identify the constraining constraints of an economy. It is also a critique of the Washington Consensus (WC), a set of overarching, if not stopgap, policy recommendations backed by the International Monetary Fund and the World Bank. The WC has failed to deliver higher and sustained levels of investment in many emerging economies.

Hausmann et al. argue that a growth diagnostic approach is needed to narrow down the most appropriate policy interventions to remove key barriers to investment. Setting the lofty goal of solving all problems or distortions at once (like WC) is unrealistic. The arguments of Hausmann et al. are summarized below.

There are four typical reform strategies, which Hausmann et al. are inferior to the growth diagnostics approach.

The first is “comprehensive reform”, in which all problems are simultaneously eliminated. It’s practically impossible. First, policy makers lack relevant information on all the distortions to carry out a comprehensive reform. Second, the pursuit of reforms everywhere strains and exhausts institutional capacities.

The second is “do as much reform as you can, as best you can,” which is the mainstream approach and a whitelist approach to reform. This simply applies to reforms that seem feasible, based on the idea that the more areas reformed the better, and that any reform is good. This is flawed because we cannot be sure that any given reform in isolation can be guaranteed to be good, due to many other issues with which it might interact. For example, a doctor may prescribe a drug that is good for the patient on its own, but when taken in combination with other drugs, it may have contraindications and lead to increased harm.

The third is second-best reform, which prioritizes reforms that lead to positive second-best effects. But it’s often difficult to predict second-best interactions before they happen. Although we are aware of the possible negative effects of the interaction of feasible reforms, we cannot predict at the outset what the costs will be. The total transaction costs of a controversial reform, for example, appear only after the fact.

The fourth strategy criticized is that if second-best interactions cannot be determined, reformers can choose to target the largest distortion. But that does not guarantee that the reforms with the greatest impact on economic well-being and growth will be worked on first. The largest distortions do not necessarily correspond to the realization of the largest net benefits to society. (Take, for example, the higher corporate tax, compared to countries in the same region. We can admit that this is a big distortion. But the investors themselves do not consider the higher tax as the most binding constraint.)

We therefore cannot afford to undertake what Hausmann et al. call it a “gun” approach, which has too many targets. As global experience has shown, this is not only ineffective; it also leads to unintended negative consequences, making the situation worse.

Besides politics, capital, time and resources are finite. These limited resources are therefore better used to work on the most important reforms.

The solution is to focus on the most binding constraints, or key issues, that offer the most “reform return on investment”. This approach focuses directly on the bottlenecks. It is these obstacles which, if not removed, would cripple the economy. Overcoming these obstacles brings a large magnitude of benefits to society, the economy or the sector.

Determining constraining constraints is not a simple task. The growth diagnostics approach uses a problem tree (Figure) to examine the immediate determinants of economic growth (eg, savings, innovation, infrastructure, etc.) rather than 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 of economic activities or the high cost of financing?

If the main problem revolves around the weak performance of economic activities, is it due to macroeconomic risks such as inflation or the narrowness of fiscal space? Or are they low social returns such as insufficient investment in complementary factors of production such as human capital or infrastructure? Or is it due to limited access to technology? Or the misapplication of property rights and contracts, labor-capital conflicts, or learning and coordination externalities?

Or is low growth mainly due to insufficient access to finance? Are there problems with domestic financial markets or external markets? If it is a problem of poor domestic markets, is it due to budget deficits or poor intermediation?

After doing a process of elimination, we can separate the non-binding constraints from the binding constraints. Once one knows what to focus on, one finds the associated economic distortions whose removal will do the most to ease the constraints on growth. Then we can proceed to choose the appropriate policy or intervention. However, this does not yet determine the exact order of political interventions. Once the primary binding constraint is properly addressed, we return to the problem tree framework for the next challenge.

To illustrate the use of the growth diagnostic framework, let us apply it to the case of the Philippines. In 2010, when President Noynoy Aquino’s term began, the binding constraint was tight fiscal space due to the previous administration’s politicized spending and reluctance to enact further tax reforms. To address this problem, the Aquino administration successfully pushed through the Sin Tax Reforms, which increased, simplified, and improved the excise tax system.

The sin tax reforms have loosened up our tax room. However, there was still a need for further tax increases to finance high infrastructure spending. During Aquino’s tenure, infrastructure spending was low and became a binding constraint.

The Duterte administration addressed the issue of low infrastructure spending, inadequacy and deteriorating infrastructure by legislating the comprehensive tax reform program. This resulted in the country’s highest tax effort since the Ramos administration. These reforms have improved our solvency and enabled the financing of infrastructure and other public goods.

Moving forward, we ask ourselves: what are the binding constraints that impede growth in the Philippines today? A comprehensive reform strategy will only waste our resources. Along the same lines, a misdiagnosis can eventually further limit our growth. Is the binding constraint the “high cost of financing” or the growing debt of the country? Are these low social returns, resulting from the COVID-19 pandemic? Is the health system or the education system holding back growth and investment? Does the infrastructure remain a binding constraint? Or have macroeconomic risks such as the threat of shrinking fiscal space and rising prices become a binding constraint?

The challenge is therefore to define a narrow target of policy interventions that respond to the removal of the most binding constraints.

The next article will focus on Marcos Jr.’s economic policy priorities and the policies needed to deal with binding constraints.

(To be continued.)

The authors belong to Action for Economic Reforms.

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