Political Economy In a Bad Economy

As the world struggles to recover from the financial crisis, developing and developed countries alike depend on effective finance ministries and their associated central finance agencies (CFAs) to help deliver good fiscal outcomes. Although ministries of finance usually assume the most prominent role at the country level, supporting CFAs can assume responsibility for a number of essential duties, including macroeconomic forecasting, tax policy, budget preparation, and debt management -- just to name a few. Given the importance of these functions in times of crisis, enhancing the capability of these agencies in developing countries is more urgent now than ever.

According to the World Bank's recently released Global Economic Prospects report, Euro Area debt problems and weakening growth in several big emerging economies are dimming global growth prospects, and developing countries should prepare for further downside risks. Moreover, the report notes that developing countries have less fiscal and monetary space for remedial measures than they did in 2008/09, and their ability to respond may be constrained if international finance dries up and global conditions deteriorate sharply.

Against this downgraded growth forecast, developing countries need to do everything they can to strengthen the capabilities of their CFAs. To do so, it is highly important to take a country's political economy factors into account -- that is, to analyze the interrelations of political and economic institutions and processes that influence national decision making. By understanding a CFA's relationships with formal political institutions, administrative institutions, civil society, external actors, and other CFAs, policy makers can be more certain that proposed reforms are politically feasible as well as technically sound.

In last week's Economic Premise, "Enhancing the Capability of Central Finance Agencies," Richard Allen and Francesco Grigoli used case studies of 10 low-income countries to underscore the importance of political economy in developing strategies for strengthening CFAs. From their analysis, they noted a number of important lessons, including the unpredictable effects that heads of state can play in making budget and financial decisions, the relationship of the ministry of finance with other CFAs, and the interplay between donor requirements and country ownership.

Indeed, as the world continues to grapple with the lingering effects of the financial crisis, using political economy to develop CFA-strengthening measures is essential. Such analysis enables policy makers to filter out reform proposals that have a high risk of failure, and to invest their resources in pursuing those that have the highest potential for success. Moreover, taking into account a country's institutional environment provides a better approach to reform -- focusing more on policies that "best fit" a country's particular situation rather than on "best practice" alone. In an uncertain economic climate, such considerations may provide a valuable tool for policymakers to enhance the capability of their CFAs and to ensure the best fiscal outcomes.

This blog was originally posted on the World Bank Institute Growth and Crisis Website.