EC1-022-A-I
ECONOMIC POLICY SIMULATOR. COUNTRY 1
Original written by professor Gayle Allard at IE Business School.
Original version, 13 May 2005. Last revised, 2 June 2015.
Published by IE Business Publishing. María de Molina 13, 28006 – Madrid, Spain.
©2005 IE. Total or partial publication of this document without the express, written consent of IE is prohibited.
JUGGLING DEBT AND DEVELOPMENT: EXPERT ADVICE FOR A PRESIDENT
It had been a particularly hard day at the office, and the man in a rumpled business suit closed the
door, lowered the blinds and took the phone off the hook in an effort to clear the confusion of the
moment and set his thoughts in order. The events of the day spun around his mind as he sank into
his chair. This morning it had been the announcement that the unions, once his most loyal allies,
would join in a mass protest against his pension reform plan. Before lunch, there was the call from
the International Monetary Fund requesting an urgent meeting to discuss why he had failed to meet
the targets of his stabilization plan. In the afternoon, the latest inflation figures –two full percentage
points above what his advisors had expected— were released, and the currency, already reeling
from the recent U.S. decision to raise interest rates, took a beating on international markets. Then
the representative of the national business organization requested an audience to express concern
over government plans to liberalize international trade. And he had just walked out of a meeting
where he and his top cabinet members had debated for more than four hours over how to cut
government spending in order to bring down a budget deficit that continued to defy control.
Unsurprisingly, there was no agreement; no one would be the first to volunteer to cut the budget of
his or her own ministry.
How could a picture that had looked so bright only months ago, when he had sailed into the
presidency on the back of a popular landslide, turn so dismal, so fast? The crowds that packed the
streets to welcome him on the day he took office had believed that he could perform the miracle of
reducing widespread poverty and severe inequality while inspiring confidence among foreign
investors, whose funds the country so badly needed. The tumult of the crowd had been music to
his ears. He, too, had waited all his life for this opportunity. And in the first months, even in difficult
negotiations with foreign bankers and multilateral institutions, he had clung to his optimism. There
was a way to achieve social justice while keeping the country financially solvent. It only required a
person with enough charisma, enough heart, enough imagination and enough confidence from the
people of this country. It could be done.
And now here he sat, watching his illusions dissolve one after another. Maybe the critics were right.
Maybe a large, poor, half-industrialized but still backward country like this one had to make a
choice between serving social needs and serving foreign investors and banks. Maybe the juggling
act just couldn’t be performed.
His eye alighted on the report on his desk that had been handed to him this morning, with official
projections for the main economic indicators1. There was some good news: GDP growth was
beginning to bounce back after near-zero growth last year. This would make a dent in an
unemployment rate that looked intolerably high to a president who promised jobs for the masses.
The dark side of the picture was that inflation, always lurking in the background, was likely to turn
1
See Table 1 in the Statistical Appendix for full information on the main economic indicators in the previous and current
years (Year 4 is the current year), and projections for the next two years (Years 5 and 6).
1
IE Business School
ECONOMIC POLICY SIMULATOR. COUNTRY 1
EC1-022-A-I
out higher than the 4% his government had hoped for. And the budget deficit looked like it would
also overshoot the target set in the IMF agreement.
The patterns emerging from the data were not new. Over the past four years, the country had also
alternated between slow growth and high inflation, always accompanied by high unemployment
rates. Economic experts had explained that the root cause of the high inflation and high
unemployment was the country’s lack of good infrastructure, especially in the transport and power
sectors, to support the strong growth needed to create jobs. These bottlenecks tended to boost
inflation whenever real GDP growth accelerated past 3.5%-4. Experts estimated that to eliminate
these bottlenecks, investment had to be sustained at between 22% and 25% of GDP. Last year,
total investment was just over 18% of GDP, with about 11% of that figure coming from foreign
investors.
How different the future of this country had appeared when it first began to industrialize several
decades ago! Then it was widely perceived as the great promise of the 20th century. Importsubstitution policies had given it a strong middle-technology industrial sector which was still
attracting some foreign investment, but which had never fulfilled the dream of being able to
compete on international markets. Now, rising labor costs and fierce competition from other
developing countries, particularly in Asia, had made the industrial sector even less competitive, and
some businesses in the vulnerable footwear and textiles sectors were relocating production to
China and in some cases Africa, in order to compete. Where export growth was now strongest was
in commodities, due to soaring Chinese demand, and while the rising prices and strong sales were
welcome –last year this country showed its first trade surplus in several years--, the change might
turn back the clock on the dream of finally joining the “club” of industrialized economies 2.
Still, it seemed it should not be impossible to juggle the joint pressures of Chinese competition,
domestic social needs and scarce financial resources if only the country were free of debt. But the
high foreign debt was its starkest reality. In those optimistic years when it appeared that everything
was possible for a developing country like this one, both clean and corrupt governments had
obtained huge loans to finance development from overly optimistic international bankers. With the
economic slowdowns of the 1970s and 1980s and the rise in international interest rates and dollar
values, the size of the debt relative to GDP had exploded, and nearly half of it –45% this year—
was owed to foreigners. This meant that developments on international financial markets had
become one of the government’s most pressing concerns. Hong Kong was far away, yet a run on
the Hong Kong dollar could easily produce a collapse of this country’s currency. And negotiations
with the IMF over stretching out the repayment of the debt owed to foreign bankers were the single
most important factor in determining the government’s economic policy.
The debt had overshadowed every argument during his cabinet meeting this afternoon. With such
pressing social and economic needs, every minister had reasons to demand to at least be able to
maintain spending in his department. The poverty programs, the infrastructure projects to eliminate
those “bottlenecks” that caused inflation, the need for better schools and universities, better
hospitals, basic sanitation: who could say no to these? Yet he had no choice but to cut public
spending. In fact, his government had kept spending under such strict control that it currently
showed a primary budget surplus: tax revenues were significantly higher than government
spending before the debt payments were made. But the huge burden of interest payments turned
this surplus into a chronic budget deficit, which had to be financed with additional debt, leading to
more interest payments, larger deficits, more debt…the vicious cycle that appeared inescapable.
And raising taxes to reduce the deficit was a step he preferred to avoid. Taxes in this country were
already quite high –fiscal pressure was 36% of GDP3--, and raising them could chase away the
private capital that it needed so badly.
2
See Table 2 in the Statistical Appendix for information on the structure of exports and imports. The United States is this
country’s largest foreign market.
3
Note that fiscal pressure includes taxes from all sources. This explains any contradiction with the figures in the
simulator.
2
IE Business School
ECONOMIC POLICY SIMULATOR. COUNTRY 1
EC1-022-A-I
What options did he have to bring the economy out of a situation where debt, social needs and
scarcity were pressing on all sides? Borrowing from the central bank to finance the deficit was no
solution, as the country had learned from disastrous hyperinflation experiences in its past. To
declare a debt moratorium was tempting, but he knew how that would hurt the country’s credit
rating; several episodes of nonpayment of foreign debt in the distant past still haunted potential
investors in this country. Foreign direct investment could solve some problems, but investors
demanded not only economic stability, but structural reform in order to be willing to invest. The
country ranked relatively low on indicators of internal market freedom and protection of private
enterprise, and relatively high on indicators of corruption,4 yet he knew that structural reforms
would be fiercely resisted by privileged elites and other interest groups in the country.
Darkness fell as he sat at his desk, overwhelmed by the terrible dilemmas faced by his
government. He was an honest man who loved his country, and his deepest hope was to be able to
put it on the road toward greater development and social progress and to lift millions of his
countrymen out of poverty. But that hope was beginning to evaporate.
Then he remembered an independent economist whom he met at the beginning of his presidency,
who assured him that the country’s problems did have a solution. In the euphoria of his first months
in office, the economist’s offer of help had not seemed necessary. Now he opened the drawers of
his desk and searched for the card that was handed to him at that meeting. There it was! He
picked up the phone and dialed the number.
You are the independent economist who answers the phone that evening. You promise the
president that you will review all of the data and come up with a coherent economic policy for the
next two years that will address the country’s problems while keeping it financially solvent and
promoting growth. You plan to structure your report to the president as follows:
1.- Very briefly, you will evaluate recent economic trends, noting which aspects of the country’s
performance are “normal” and which represent departures from conventional models or rules.
You will explain any departures.
2.- You will also characterize briefly the economic policies and policy “mixes” that have been
followed recently; and their consequences on the economy, both those you can observe and
those that you anticipate.
3.- You will rank the country’s greatest constraints, in order of importance.
4.- You will outline a coherent program that addresses those constraints and the government’s
objectives of economic stabilization, development and poverty reduction, while being politically
feasible.
(You use the attached spreadsheet to experiment with the quantitative effects of your policy
proposals before designing your definitive program for the president. The spreadsheet incorporates
simple relationships among the economic variables described above, omitting the impact of trade
and exchange rates.)
As the president’s door opens on the day of your scheduled meeting, you see that it is not only the
president who rises to greet you, but his entire cabinet and staff of advisors. And suddenly you
realize how important this presentation is. The future of the country is in your hands.
4
See Table 3 in the Statistical Appendix for some institutional indicators for this country, and their comparison with other
countries or groups of countries.
3
IE Business School
ECONOMIC POLICY SIMULATOR. COUNTRY 1
EC1-022-A-I
STATISTICAL APPENDIX
TABLE 1: KEY ECONOMIC INDICATORS
Year 1
Year 2
Year 3
Year 4
(current year)
Year 5(p)
Year 6(p)
Real GDP %
4.3
1.3
1.9
0.4
4.1
3.6
Government consumption %GDP
19.1
19.3
20.1
20
Budget balance %GDP
-3.4
-3.3
-9.8
-4.9
6.5
5.8
Inflation (% CPI)
7.0
6.8
8.5
14.7
Public debt %GDP
49.4
52.6
55.9
57.4
Unemployment rate (%)
13.3
11.3
11.7
12.3
Current-account balance as %GDP
-4.0
-4.6
-1.7
0.9
11.2
(p) indicates projected values.
TABLE 2: STRUCTURE OF IMPORTS AND EXPORTS FOR COUNTRY 1
Major exports
% of total
Major imports
% of total
Transport equipment and parts
16.4
Machinery and electrical equipment
28.2
Metallurgical products
10.4
Chemical products
18.0
Soybeans, bran and oils
9.8
Oil and derivatives
13.3
Chemical products
1.9
Transport equipment and parts
10.8
TABLE 3: SOME INSTITUTIONAL INDICATORS FOR COUNTRY 1
INDICATOR
Score Country 1
Score U.S.
Protection of property rights (higher=better protected)
4.9
8.2
Regulation of business (higher=less regulated)
5.0
7.7
Freedom to trade internationally (higher=freer)
6.8
7.8
Number of procedures needed to start a business
17
6
Time needed to fire a worker (days)
152
25
Number of procedures needed to fire a worker
14
4
■■■
4
Score OECD avg.