Managing the Indonesian economy: Some lessons from the past

Abstract

This paper draws some tentative lessons for the management of Indonesia's economy from recent political–economic history. After a brief review of the economy under the present government, the paper then puts the picture in the longer term perspective of post-independence Indonesia. Some lessons are then drawn. They include the need to maintain awareness of the close connection between economics and politics, constant vigilance about economic stability and the budget, a solid economic team, a coherent overall strategy and a focus on institutions and governance.

The purpose of this paper is to draw some broad lessons from the past for the present management of the Indonesian economy. Some of them turn out to be fairly obvious and the value of the exercise is essentially to remind us of their importance in economic policy. But all the underlying issues have their roots in the past; they have become recurring themes in the political–economic history of modern Indonesia and will probably continue to be so for some time to come. I will start with a quick review of the economy under the present government, then put the picture in the longer perspective of post-independence Indonesia, and finally draw some lessons.

Indonesia 2005

After a rather incoherent first 100 days, due partly to organisational teething problems and partly to having to cope with the emergency situations resulting from the Aceh tsunami and other natural disasters, the Susilo Bambang Yudhoyono and Jusuf Kalla (SBY–JK) government has managed to compose itself and begin to deal with the country's pending economic problems and other long-standing issues.

Now, after more than 11 months in office, the government appears to have made tangible progress in some areas, but has still to prove its ability meet the challenges in others, notably in maintaining macroeconomic stabilityand growth momentum. Until the middle of the year, things seemed to be going as they should. The economic stability that had been established during the previous administration looked set to continue, while economic growth seemed to be gaining momentum. Inflation had been brought down from over 15% in February 2002 to 6.4% at the end of 2004 and, with appropriate policies, it looked as though it could probably be contained at 7–8% in 2005. But events during August and September have tilted the balance of risks toward higher inflation, greater financial vulnerability and perhaps also slower growth in the coming months.

In April 2005, and again in June, spells of market jitters caused sharp movements in the exchange rate; although the market calmed subsequently, by mid-year the value of the currency had gone down against the dollar by some 7% from its January level. The comforting fact was that the rupiah was not alone in its downward slide: over the same period the baht, the yen and the euro, for instance, depreciated against the dollar by a roughly similar order of magnitude. More disconcerting was the fact that during the period Indonesia lost some $4 billion in reserves by supporting the rupiah, a policy not repeatable without causing concern about the adequacy of the country's reserves—and indeed, about the basic stance of its macroeconomic policy.

The rupiah began to depreciate sharply in the second week of August—falling by about 8% against the dollar in the last two weeks of August alone—and has since strayed from the general trend of the regional currencies. Foreign exchange reserves have also gone down by another $2 billion since mid-year. The immediate concerns of the market appear to be twofold: the rapidly growing oil import bill and fuel subsidies resulting from the government's reluctance to adjust domestic fuel prices in the face of rising world oil prices; and the viability of the central bank's prevailing interest rate policy in the face of rising inflation and tightening international financial conditions. The broader concerns include a perceived lack of coordination among policy makers in responding to the emerging challenges. Three questions have crystallised in the market. What will the government do in relation to fuel subsidies? What will Bank Indonesia do with its monetary policy? What will the government do to improve coordination in its policy making?

After a spell of inaction (aside from some ineffectual interventions in the foreign exchange market), Bank Indonesia responded on 30 August by raising its policy rate by 75 basis points, with a promise of follow-up action later. The announcement was well received. One day later the government announced a policy package that outlined plans for addressing market concerns (including fuel price adjustments in the near term), but because it lacked specifics it failed to impress the market. On 6 September, Bank Indonesia kept its promise to follow up the previous policy adjustment, announcing a further 50 basis point increase in its policy interest rate. By the time of writing (the third week of September 2005) investor jitters seemed to have declined and redemptions from the mutual funds to have slowed, but general market conditions remained somewhat unsettled as the market awaited further reassurance from the government.

The financial market disturbance is regrettable, not only because the sustainability of macroeconomic stability is now being questioned again, but also because the country's economic fundamentals are in reality not so bad as to prompt such negative market reactions. It is true that Indonesia has become a net importer of oil since around 2003, but it remains a net exporter of oil and gas— albeit with a net balance that has recently been declining rather rapidly. This means that, with timely domestic fuel price adjustments, the budget and the balance of payments positions this year and next should remain manageable. In the medium term, with appropriate incentives, the country's net exporter status in energy can still be maintained for some time to come. On the monetary front, Bank Indonesia appears to have overcome its early hesitancy to use its interest rate instruments to respond to the evolving inflation dynamics at home and the changing scene in international finance. At this stage monetary policy seems to have done its share of adjustment. The recent actions by the central bank reflect sound exercise of its independence, and the ball is now in the government's court. With more timely and coherent responses from the government there is every chance that the country can ride out the present storm.

It is important that market conditions be restored to normal quickly so that no permanent damage is inflicted on the economy, and especially on the financial sector. So far this has not happened. In fact, during the last year the general performance indicators of the banking sector have continued to improve, though in the potentially stressful environment of rising interest rates and a volatile foreign exchange market, Bank Indonesia cannot afford to relax its vigilance. The central bank's watchful eye has lately fallen on lending for consumption and property development, which have grown extremely rapidly in the last few years. Recently uncovered scandals involving the state-owned banks underscore another class of problem—that of poor governance—which, if unaddressed, could cause another banking crisis. One promising solution to the problem, expeditious privatisation of those banks, does not appear to have enthusiastic support in the government.

Growth momentum picked up strongly in the fourth quarter of 2004, but sub-sequently moderated. During the previous administration economic activities revived rather slowly, but quite steadily, as reflected by the gradual acceleration of economic growth from 3.8% in 2001 to 5.1% in 2004. However, the peaceful elections and smooth change of government in 2004 greatly boosted market confidence, which translates into larger capital inflows and a revival in investment. The recent financial turmoil has obviously dented confidence, but provided the instability can be quickly brought under control, 2005 as a whole is likely to see the economy growing at a little under 6%, and driven by investment rather than consumption, thus ensuring, if maintained, a more solid basis for future growth.

There is at present a strong awareness at the top that boosting investment is the only way to achieve the high economic growth that in turn is key to creating more jobs and reducing poverty, as promised during the presidential campaign. An important policy in this context is the recent effort to restart investment in infra-structure—viewed as the most immediate constraint on growth—though concrete results are yet to be seen. There have also been renewed initiatives in the oil and gas sector. Motivated by the extraordinary world price developments and domestic shortages, the government aims to revitalise production by offering new incentives for investors in this sector. It is hoped that the new schemes will attract strong interest in the 70 new blocks to be offered during 2005–06.

But, of course, investment needs to be revived in many more sectors. This requires a broader program to improve the general climate for business and investment. In this connection new investment and tax laws have been in preparation for some time now, and reportedly will be ready for submission to the parliament soon. Some parts of the labour regulations that hinder labour market flexibility are also being looked into. The recent anti-corruption drive, with investigations leading to prosecutions in several high-profile corruption cases, has given a positive signal to the market, as has the accord toward a peaceful settlement for Aceh—an achievement that is likely to have importance well beyond economics.

There may be progress in other areas as well. But as yet, I have to say, it is difficult to see how all the initiatives hang together to form a comprehensive strategy to promote investment. There are also grey areas that need clarification, such as the privatisation policy and the main direction of trade-cum-industrial policies. Perhaps someone in the government should attempt to draw up a coherent overall picture, preferably itemised as time-bound, clearly defined actions, the progress of which can be monitored by the public.

Recently there has been a flurry of press reports about the re-emergence of cases of malnutrition and common diseases such as polio and malaria that we thought Indonesia had been freed from since the New Order era. They drew reflex responses as well as more reflective ones from the government. The events have put pressure on the government to come up with an action program and, better still, a strategy for the health and nutrition sector. It may well be that the government would find that what the New Order did in this sector—and, indeed, its basic needs programs in general—are worth looking into.

In summary, the present government is now facing a real test of its resolve and ability to maintain economic stability and other gains that had been secured by previous governments. In some areas it has actually managed to carry those gains forward, but there remain other important areas that need clearer direction, and there is a need in all areas for evidence of a continued commitment to reform. The following discussion places the Indonesia of 2005 in a longer historical perspective, focusing on broad political–economic factors that have significantly conditioned economic policy in this country.

Indonesia 1950–2005

To set the stage let us make a quick trip back in time.

During the era of parliamentary democracy in the 1950s, political instability and the resulting rapid turnover of governments denied the country a lasting solution to the problem of macroeconomic imbalances that had plagued it almost continuously since independence. No single government in the period was able, or willing, to tackle the chronic twin-deficit problem—simultaneous balance of payments and budget deficits—at its root. Instead, every government at that time preferred to resort to stopgap measures—with variations, but basically in the form of some combination of ad hoc monetary policy, exchange controls and a multiple exchange rate system—to win the economy another reprieve.1 As time passed, economic conditions became worse, eroding the legitimacy, and contributing to the eventual demise, of the old political order. In this period failure in politics caused failure in economics, which fed back into failure in politics.

Guided democracy was then the most appealing alternative on offer, promising a more stable and more decisive government and, it was hoped, better economic conditions. It turned out to be another disappointment, however. The apparent political stability did not bring with it an improved environment for economic policy. In fact, during this period economic policy making in Indonesia was at the lowest ebb in its history.2 Politics was everything: economic problems were to be solved politically. Energy was spent more on creating images than on alleviating real-life problems. The doctrine of guided economy, which exalted the state and distrusted the private sector, and which preferred regulations to incentives, had aggravated rather than relieved the scarcity problem. Macro imbalances were left to grow untamed, first out of neglect, but later out of despair. People were losing their faith in the rupiah, and hyperinflation set in while the economy first stalled and then regressed. At some point the situation became so untenable that the only way out was regime change. Sadly, this was a violent process involving an enormous cost in human lives. The theme of the 1950s recurred: a political order that led to economic failure eventually collapsed.

The New Order opened up a fresh direction for the country. Astutely tapping the ingenuity of its economic team, the regime moved decisively and systematically to mend the broken economy.3 It brought hyperinflation under control through tight fiscal and monetary policies, and set the economy in motion again by dismantling the web of stifling regulations and opening (or reopening) to the world. For more than three decades, through good policy and spells of good fortune (oil booms, in particular), the Soeharto regime delivered almost continuous economic and social progress unparalleled in the history of Indonesia. Tragically, a severe crisis triggered a tumultuous and abrupt end to the regime. It is now being discredited as corrupt, while being credited with very little.

Some perceptive observers had indeed detected the seeds of the New Order regime's decay some years before its eventual demise. But the truth is that until a rather late stage in the crisis not a few of us (including myself) thought that the damage inflicted could be fairly expeditiously repaired, and that the economy would then resume its long-term growth. Subsequent events proved otherwise, of course. The damage turned out to be much more extensive than at first seemed likely. The nature of the regime had denied the country an adequate mechanism for checking the cumulative growth of corruption, nepotism and other narrow interests that had come to complicate, and increasingly to impair, the quality of economic policy in later years. The demise of the New Order highlighted a new lesson—the importance of the quality of institutions in the development process. The cause of the regime's downfall was not its inability to bring about economic progress or to maintain political stability, but rather the inability of existing institutions to self-correct and respond coherently to the unexpected stresses and strains that have become more common in the globalised world. But a more balanced assessment of the New Order probably has to wait until we gain a better perspective of the recent far-reaching changes in the political economy of the country.4

Thus began the reformasi era. Despite its short tenure and having to operate in caretaker mode, the government of Soeharto's successor, B.J. Habibie, succeeded in preventing the imminent collapse of the economy, stabilised it and partially reversed the downward slide. In the realm of politics, several basic reforms were initiated, paving the way for deeper democratic reforms later. Unfortunately, these achievements were subsequently overshadowed by the unfolding of a high-profile corruption scandal (the Bank Bali case) and an explosive political event (the secession of East Timor).5

In October 1999, Abdurrahman Wahid, then a shining symbol of democratic reform, was elected president through a free and transparent process. Expectations were high, and reform fervour was at its peak. However, the euphoria soon turned to disappointment as delivery fell short of expectations. The cabinet and its economic team were the product of political compromises, and were therefore rather heterogeneous—a circumstance that required strong management if it was to work effectively.6 President Wahid's formidable intellectual capacity and moral courage could not compensate for his physical handicaps and lack of managerial proficiency. The rather high turnover of ministers, and the discord between the government and the central bank that occurred subsequently, did not help the situation.7 Meanwhile, for various reasons, regional unrest and local conflicts escalated, diffusing focus, draining resources and depressing confidence. There was some progress on political reform, such as in regional autonomy and constitutional amendments, but the economy floundered and economic stability was again in danger of being lost. Relations between the president and the parliament turned sour and eventually grew into confrontation, forcing the elected president out of office after only 21 months.

Megawati Soekarnoputri, then vice president, with fairly wide support from political parties in the parliament, was sworn in as president for the remainder of Wahid's five-year term. The cabinet, inevitably, again had to accommodate political compromises, but this time some important portfolios, including certain economic ones, appeared to be more insulated from the direct horse-trading process. In terms of its cohesiveness and like-mindedness, so important for coherence and decisiveness in action, I would rate the resulting economic team one notch above the previous one but certainly not comparable with the New Order team (especially in the earlier years).8 On the economic front, the priority was pretty clear— to re-establish economic stability and then accelerate growth to absorb the rising number of unemployed and to reduce poverty. The political situation was calmer than that during the previous administration. Security conditions had improved somewhat and relations with the legislature were generally in working mode. This period also witnessed the adoption of some fundamental constitutional reforms delineating the role of the executive and the legislature, and the structure of the latter (MacIntyre and Resosudarmo 2003). Later, the government oversaw free and peaceful general elections with a tolerable level of irregularities. In its 39 months in office, the Megawati government succeeded in re-establishing economic stability, but was less successful in accelerating growth, largely because it lacked a solid and focused program for achieving this goal.9 As noted, there was also progress on a number of political fronts, but in other areas the record was quite mixed.

The election process and the ensuing change of government in 2004 were notable for the air of normalcy that is observed in a mature democracy. As noted earlier, the SBY–JK government is currently facing real challenges in consolidating economic stability and other gains secured by previous governments, while in some areas it has been able to move forward. Taking a longer perspective, it seems justified to say that in the past few years Indonesia has made slow but significant progress, both in economics and in politics. But it is clear also that the road ahead is long and perilous. The lessons of the past may give some clues as to possible hazards and the way forward.

Some lessons from the past

Beware of possible disharmony between politics and economics

We have seen that much of Indonesia's modern history is about powerful interactions between politics and economics. One historical truth is that the dynamics of politics and those of economics are not naturally in harmony with each other and, when they are not, setbacks in both politics and economics eventually result. What we need is not only a keen awareness of these facts but a conscious effort to make the two forces mutually reinforcing at every stage of the transition, rather than mutually destructive. Allow me to elaborate this dilemma.

On the one hand, we know that to build a viable democracy with all its essential elements—basic security, rule of law, responsible political parties, a well-informed citizenry, a professional bureaucracy and so on—will take a long time. On the other hand, people expect improvements in their living standards now. The experience of the 1950s is a vivid reminder that we must first survive the short run to secure long-run gains. For the present experiment in democracy to succeed, the economy must therefore be able to deliver benefits, not some time in the distant future but in adequate instalments, starting now. Assuming that the government has a clear agenda for political development (and this is only an assumption), its task is to manage the economy so that such benefits flow.

But there is a complication here. As our experience attests, economic performance itself also depends on whether a supportive political environment exists. Thus even if the government had all the right ideas on how to manage the economy, it might find it hard to put them into effect because a supportive political environment did not exist. To highlight the dilemma, perhaps I may be excused if I make an oversimplification by saying that Indonesia currently has to deal with economic problems very similar to those of the second half of the 1960s, but within a political environment more akin to that of the 1950s. Just as in the period after the 1965 crisis, Indonesia after the 1997 crisis had to start with a broken-down economy that needed major repairs. First it needed to be stabilised and restarted, and then rehabilitated and restored to its long-term potential growth track—all of which requires decisive and systematic action. However, in contrast with the situation in the 1960s, all this has to be done within the rather chaotic atmosphere of a democracy in the making.

Our experience in the 1950s as well as in recent years suggests that the practice of democracy may constrain good economic policy in at least three ways.

First, the political process in a democracy tends to have an inherent bias toward the short term. Politicians put a premium on policies that deliver results now and postpone costs until later. Only the few visionaries among them are willing to back policies that promise long-term benefits but inflict short-term costs, even when it can be established that the gain far outweighs the pain. When politics becomes more a game of five-yearly seat grabbing contests, factors that are absolutely critical to sustaining development in the long run—such as institutions, human resource quality, natural resources, environment and technology— tend to take a back seat, notwithstanding lip service that suggests otherwise. Appearance is more important than substance, and if substance is involved, ‘short-termism’ tends to ensure that the focus is on how to divide the existing cake, rather than how to make it bigger.

Second, too much politics can result in distortion in economic policy through the undue influence of sectional and narrow interests. Pressures from the political parties, business and other trade lobbies, loud noises in the streets or soft whispers in the president's or a minister's ear, and other devious forms of pressure can and do have distorting effects on economic policy. There is one important note, though: our own experience suggests that serious distortions are more likely to happen in a non-democratic, non-transparent setting. Transparency prevents some distortions, but not all. The point here is that some areas of economic policy are quite technical and their ramifications are so complex that decisions about them are better left to professionals than to politicians and pressure groups. There is here an issue of balance between efficacy and accountability. In monetary policy this is resolved by giving policy independence to the central bank, but in my view a significant portion of fiscal policy and certain areas of trade and development policy qualify equally for some degree of insulation from day-to-day political pressures.10

Third, democracy as we see it in practice seldom goes together with decisive, swift action when this is required. We could find several examples of this in our history, although in some cases lack of leadership and bureaucratic inertia may also have contributed to the problem.

The main question, then, is this. Can the present political system in Indonesia provide an environment that enables:

• economic policy to strike a reasonable balance between short-term and long-term priorities;

• the economic policy process (or a significant part of it) to be more professionally managed, with sufficient insulation from undue political pressure; and

• government to take decisive and rapid responses when necessary?

The answer has to be yes, or else we have to rethink the experiment. Affirmative answers to all the above questions are essential for effective economic policy. And we know that economic policy that is capable of delivering results is indispensable for the survival of the political order. It seems, therefore, that political and economic reformers should work more closely together.

A number of possible actions may help improve the aforementioned aspects of policy making, including the following:

• strengthening and empowering the national planning agency to enable it to act as an effective guardian of long-term aspects of all major economic policies;

• designing arrangements that make formulation of the relevant parts of fiscal, trade and development policies more technocratic than political;

• avoiding ad hoc policy decision making, and making sure that all important decisions have to go through clearly identified fora, in accordance with clearly defined decision procedures; and

• developing networks for rapid policy response, with strong coordination mechanisms—especially in areas potentially disposed to crisis (for example, the Financial Safety Net being developed to respond to future banking crises, in which mechanisms and procedures involving the finance ministry, the central bank and even the parliament are spelled out clearly).

All such institutional arrangements will help. But in a country where many things are still in the formative stage, I can clearly see the critical role of leadership, or statesmanship, or whatever we may call it. Fareed Zakaria, among others, stresses the role of elites (from all walks of life) in setting the course of a nation's democratic development (Zakaria 2003: chapter 8). Their leadership inspires other members of the society with vision, nurtures their hopes, and sets professional and moral standards for them; it leads them. A society that embraces democracy but neglects to foster such social leadership is bound to drift in the sea of history. Observing post-independence history in this light one wonders if the Indonesian elite has discharged its historical responsibility as it should have.

Still related to the role of the elite, our next lesson underlines a rather obvious but sometimes forgotten truth that to get things done, choosing the right persons is just as critical as getting the institutional setup right.

Need for a solid economic team

As I mentioned earlier, the challenges that post-crisis governments have had to grapple with are not too different from those the New Order regime faced in the late 1960s and early 1970s. The success of the New Order in dealing with the economic problems of the country in those years is well documented. During the first few years in power the regime undertook a series of decisive actions and strong reforms. As a result, within two years stability was firmly established and clear signs of economic turnaround were observed. Within the following year, a comprehensive five-year development plan was launched, setting the stage for an unprecedented record of sustained growth over a long period.

A key factor that contributed to that success was the presence of a strong economic team. The team was effective because its core consisted of like-minded professionals who had developed mutual trust out of long personal association and, just as importantly, because the team had a clearly recognised intellectual leader in Professor Widjojo Nitisastro. With the full trust and backing of the president, the closely knit team drafted and (later, as ministers) implemented the whole sequence of economic policies—from the stabilisation stage to the rehabilitation stage and then the development stage—thus guaranteeing their coherence and consistency. In those years, and in fact throughout the New Order period, the team always operated under the protective umbrella of the president, which was key to its ability to implement difficult reforms. In later years, however, the critical communication channel to the president had to be shared with others who offered alternative visions and views on how to manage the economy and, increasingly, also with narrower interest groups, making the economic policy process more complicated, and policies overall less effective.

In the present political setting it is neither possible nor, strong proponents of pluralism would say, desirable to re-enact this history. But the plain fact remains that incongruence of the views within a team, too much ‘noise’ interrupting the channels of communication with the president, and feeble presidential protection of the team all lessen the effectiveness of economic policy making. In the final analysis, it is the task of the CEO of the country to come to the best workable balance between the need to secure maximum policy effectiveness and the imperative of accommodating political realities.

Need for a coherent and credible strategy

Another lesson that we can learn from New Order economic management is the coherence of its strategy. The core of its macroeconomic and development policies basically derived from mainstream economics with some Indonesian emphases added, especially to the latter. It included prudent fiscal and monetary policies, reliance on markets, open trade and investment policies, provision of adequate infrastructure and, with an apparent Indonesian touch, special emphasis on agriculture, massive expansion in the provision of basic needs (food, health, education, housing), population policy and a transmigration program. One may agree or disagree with part or all of the strategy, but it was clearly a coherent one. Its ‘mainstreamness’ helped assure its coherence, but in my view it was the presence of a strong intellectual leader within the team that was mainly responsible for that quality.

Moreover, the strategy was implemented with a high degree of consistency over a long period. This created a predictable environment and provided sufficient comfort for domestic and foreign investors to join in the action in great numbers. The strategy worked well until the 1997 crisis broke, when the economy's major shortcomings—weak institutions and poor governance—began to surface. I will return to this below.

The main point here is that a clear picture of how the various individual policies hang together, showing the broad direction in which the economy is being steered, is absolutely essential—for both the government itself to coordinate its actions, and for economic actors to determine their responses. The strategy must also be perceived as credible, being backed by commitment to action on the part of the authorities. The strength and credibility of the New Order strategy derived not from what the government said it would do in the many volumes of the Repelita (five-year plan) documents, but from the real actions taken by the regime over the years, as monitored and perceived by economic actors.11

In the present political setting it is probably more difficult to come up with such a coherent strategy, but it is not impossible. Much will depend on the clarity of the government's vision, its technocratic capacity to translate this into operational policies, and its skill in maintaining the essential elements of the strategy and protecting its overall coherence, while accommodating elements thrust on it by political realities. Paradoxically, from the viewpoint of economic management, the need for a coherent strategy as a policy anchor is more acute in a democratic setting, where the risk of policy swings is often perceived by economic actors to be greater.

The content of the strategy basically involves political decisions. But as I implied above, its core must contain solid technocratic substance, or else it only serves as a wish list. As for the substance itself, I believe that in today's world the options open to a country like Indonesia for conducting its economic and development policies are limited. In the end the one chosen from among the feasible options may not be too far from mainstream ideas—which themselves are evolving. In my view, the basic thrust of the New Order economic strategy—prudent fiscal and monetary policies, market-oriented microeconomic policies, open trade and investment regimes, adequate provision of infrastructure, emphasis on basic needs—is realistic in the present global setting. It is also basically sound, as it proved capable of delivering results for so long. However, in light of the experience of its implementation in the later years of the regime, and our experience since the crisis, it does appear to require adjustments, which in some areas may be very significant. Such areas include the strengthening of institutions and governance (‘soft infrastructure’), financial sector strategy, domestic competition policy, management of natural resources and environment protection, strategy on small-scale enterprises, and perhaps more. Reworked policies can then be integrated into the basically sound core strategy. The view that governments in the post-crisis era should make a clean break with the past and develop a completely new strategy from scratch is, if taken literally, not an intelligent position to take. There are useful lessons of the past which, if followed, may save us a lot of unnecessary trouble in the future.

Never take stability and the budget for granted

It is a historical fact that, compared with its neighbours, such as Singapore, Malaysia and Thailand, Indonesia's performance in relation to economic stability has not been outstanding, even when we include the extended period of relative stability of the pre-crisis New Order. Compared with the experience of those countries, Indonesia's inflation and interest rates have quite consistently been on the high side, and its exchange rate more volatile. Thus keeping the maintenance of economic stability at the top of the national agenda seems to be entirely appropriate. It will take some time, and persistent effort, before Indonesia can match the stability norms of the region.

It is an interesting question why Indonesia is more prone to instability than these other countries. I suspect that some of the explanations lie outside the realm of economics, but here I wish to highlight one main pillar of stability—government finance—which has served as a crucial link between political dynamics and economic performance in Indonesia.

We may recall that during the parliamentary democracy era in the 1950s the twin-deficit problem was left hanging and untackled. Governments then were either unable or unwilling to come to grips with the root cause of the their own finances—letting the problem become worse over time. The state of public finance mirrored the state of politics. In the guided democracy era much the same thing happened again, even more obviously. Public finance had become the pawn of never-ending political adventures. Within a few years the state was bankrupt and the economy in a mess. When the New Order regime came to power there was a conscious attempt to begin insulating public finance from the vagaries of politics. The ‘balanced budget rule’ was adopted to achieve just that and, as a result, the country was able to enjoy a long period of relative stability. But then in 1997 the crisis broke and the budget had subsequently to absorb an enormous burden resulting from that calamity. Large private debts were transformed into public debts. Through its budget the government again served as the nation's paymaster of last resort, though this time more out of economic imperative than because of regime-related impotence or political adventures. Since the crisis, the goal of fiscal policy has evolved from survival to consolidation, and then to its re-establishment as an anchor of economic stability.

Looking ahead, formidable tasks await the present and future governments. Making fiscal policy the anchor of stability requires more than balancing annual budgets and reducing the debt ratio. The first thing the government should do is to re-establish a firm compact about the basic rules of fiscal prudence (some variant of the balanced budget objective and the adoption of market-determined domestic fuel prices may be a good start). This will insulate fiscal policy from the most damaging political pressures. Second, it should undertake a comprehensive reform of all aspects of the antiquated system of government finance administration. Reform and modernisation of tax administration should be given the highest priority, because of its critical role in securing fiscal sustainability in the long run. Some efforts have been initiated already along these lines. The basic laws on government finance have been passed, and a blueprint for modernising the ministry of finance (including reform of the treasury and budget operations as well as tax and customs administration) has been completed.12 Such efforts will bear substantial fruit, but only in the long run, and so need to be sustained by strong leadership from the top. Third, the government should transform its currently rudimentary debt management unit into a best-practice system for managing government debt, encompassing not only direct debts but also unfunded liabilities—the most important being the government's obligations to the civil service pension scheme—as well as its contingent liabilities, in the form of the implicit and explicit guarantees currently enjoyed by the enterprises it owns. Fourth, the fiscal decentralisation process should be completed, with adequate safeguards against fiscal indiscretion at the provincial and lower levels of government. Lastly, I would urge the government to be daring enough to set the goal of achieving, over the long run, a second political compact that further insulates fiscal policy from political vagaries by giving the fiscal policy authority more autonomy—in similar spirit to, though not necessarily to the same extent as, that now given to the monetary policy authority. This would greatly strengthen the foundations of the nation's economic stability. With that, the world's best stability performance would not be beyond reach.

Never (again) neglect institutions and governance

The crisis brought not only an acute awareness of how treacherous it can be to live in an interconnected world, but also a growing realisation that institutions of society and the way they are run (governance) matter a great deal in such a world. Many now have come to accept that the reason for our defencelessness in the face of the crisis, and the extended ordeal that we have had to endure, is our weak institutions and their poor governance. The recent focus on how to improve them is a move in the right direction.

The first strategic step has been taken—a change from authoritarianism to a democratic system. Democracy is supposed to provide a better environment for developing more durable institutions and improving their governance. The catch is that the transition process to democracy itself is one that requires purposeful acts of institution building and standard setting. The initial environment has now been established, but that is just the beginning. A lot needs to be done to carry the process forward. Where should we go from here?

Of the many exercises in institution building and reform, none is more fundamental, or promises a greater payoff, than those in the legal sphere, including the judiciary and other aspects of law enforcement. For here is where society's rules of the game are actually played out. Alas, despite strong domestic public and international support, these reforms progress only very slowly. The judiciary clearly plays a central role in the reform process but, as in other areas, the government has to take a strong lead. Greater support, and perhaps also pressure, from the international community may help speed up the process, but the main force for change must be home-grown.

Next in terms of urgency is civil service reform, for herein lies the hope for more effective government and better implementation of policies. This also provides a natural framework for the current anti-corruption campaign. Like the judiciary and other legal institutions, the civil service has long suffered from neglect.13 The Japanese occupation and the revolutionary wars in the 1940s swept away what remained of the colonial bureaucracy that the Dutch had hurriedly abandoned. Unlike India, Malaysia or the Philippines, for instance, the newly independent Indonesia had to start with weak civil service traditions and meagre numbers of trained civil servants. Over the years, the service was expanded rapidly out of necessity, while the damaging influence of politics was allowed to creep in, leading to a fateful decline in performance, service quality and the integrity of its corps. The New Order regime managed to arrest, and even partially reverse, the downward drift in performance and service quality, though apparently not in integrity. This was done by gradually improving salaries, opening the civil service up to new and better educated recruits, undertaking partial reform, and imposing a form of political (as opposed to administrative) discipline. In the reformasi era the state of the civil service in all its aspects has deteriorated visibly, so far with little sign of reversal. A complete overhaul is long overdue, but no government since independence has had the resolve to take up this challenge seriously.

Conclusion

After 11 months in office the new SBY–JK government has yet to prove its resolve and competence to consolidate the gains achieved by previous governments. However, it must be recognised that it has managed to extend their progress in a number of directions—notably in kick-starting higher growth, renewing efforts to improve the business and investment climate, intensifying the anti-corruption drive, and securing an important first step toward a peaceful settlement for Aceh. But there remain major gaps in the agenda that need to be filled to complete the country's recovery and to get it back on its long-term potential growth track. Indeed, the success of the current democratic experiment hinges on success in managing the economy.

The past provides lessons that may save the country from unnecessary troubles on the long and perilous journey ahead. The lessons outlined above may be summarised as follows:

Beware of possible disharmony between politics and economics, especially in the early stages of the democratic experiment. At every stage of democratisation a sound economic basis must always be maintained and a minimum amount of economic and social improvement must be achieved. Managing the economy in a democracy still in the making needs a strong sense of direction, shrewdness and innovative institutional arrangements. Above all, the democratic experiment demands a willingness on the part of the nation's elite to provide social and institutional leadership.

In managing the economy, the solidity of the government's economic team and the nature of its relationship with the president matter a lot, as do the clarity, coherence and credibility of its economic strategy. To be effective, the team must be composed of professionals not too divergent in their views of the world, and must receive adequate support and a protective umbrella from the president so that it can take difficult positions in the best interests of the general public. A clear and coherent strategy must be developed and fully explained to politicians, the public, economic actors and the bureaucracy. Credibility can only come through demonstrated achievements from real actions. We should not start from scratch but, with clear conscience and humility, be willing to adopt those parts of the New Order strategy that proved to have worked, while recognising the need for major adjustments in a number of important areas.

Never take economic stability for granted. To achieve stability performance on a par with the world's best, Indonesia needs to strengthen the institutional basis for its stability. This includes adopting a firm political compact on budget rules, implementing comprehensive reform of fiscal administration, developing a sound debt management system, completing the fiscal decentralisation process with adequate safeguards and, at some stage, securing another compact that will ensure greater independence of fiscal policy.

Lastly, institutions and governance should receive the highest priority in the overall strategy. Start and sustain reforms in sectors that promise to give the greatest systemic payoff: the legal and law enforcement sectors and the bureaucracy. They are perhaps the most difficult to reform, but it will be well worth the effort.

Additional information

Notes on contributors

Boediono

Paper presented at ‘Indonesia Update 2005: Indonesia, Australia and the Region’, Aus-tralian National University, Canberra, 23 September 2005. I wish to thank Thee Kian Wie and Hal Hill for their helpful comments.

Notes

¹The perpetuation of the colonial structure of economic power complicated policy making, and the imposition of the burden of the huge Netherlands Indies debts on the new republic constrained the latter's room for manoeuvre. But the nationalisation of Dutch business in 1957 and the repudiation of the debts in the mid-1950s did not improve macro economic performance. Standard references on these issues include Higgins (1957, 1990), Paauw (1960, 1963) and Thee (2003).

²In this period of scanty economic information, the best systematic accounts of contemporary economic development are the four-monthly surveys of recent developments in BIES.

³Apart from the regular surveys of recent developments in the BIES, other highly readable sources on economic developments during this period are Hill (1996) and Booth and McCawley (1981).

⁴For an excellent account of the political economy of New Order economic management before and during the crisis, see Hofman et al. (2004).

⁵For a comparison of some aspects of economic policy making in the eras of Soeharto, Habibie and Wahid, see Boediono (2002).

⁶The ‘economic team’ here refers rather loosely to the group of officials directly involved in macro policy issues. This includes the coordinating minister for the economy, the minister of finance, minister for state enterprises, minister for national planning and minister of trade and industry, and the central bank governor (who is outside the government). A broader definition would probably also cover other ministers whose portfolios have direct bearing on the achievement of economic policy goals, including the ministers of agriculture, forestry, communications, labour and manpower, energy and natural resources, and public works.

⁷On the discord between the government and the central bank, see Boediono (2005).

⁸For a sketch of the economic policy making process during the Megawati administration, see Boediono (2005).

⁹In October 2003 the government issued a White Paper containing a comprehensive list of time-bound actions for sustaining economic stability and for accelerating growth through improving the climate for investment and exports. The document was intended to assure the market that, after the termination of the IMF program in December 2003, the government would continue to maintain economic stability and begin to implement a coherent action program to improve the business climate. By the time the government changed one year later, practically all listed actions in the stabilisation section had been undertaken, while those in the investment and export sections were only partially implemented. The poor implementation record for the latter was due primarily to weak ownership of the program by the relevant ministries and agencies, a weak sense of urgency at the top, and the increasing focus of the government on election-related activities in 2004.

¹⁰The case for fiscal policy independence is articulated by Blinder (1997).

¹¹All plans that have been produced in the country share a common fundamental problem whose cause is succinctly stated by Booth (2005: 208): ‘... Indonesian planners appeared to be spending too much time and energy in setting targets they lacked the policy tools to achieve, while at the same time ignoring those areas of policy where reform was necessary, and where government did have the capacity to act’.

¹²The new basic laws on government finance are Law 17/2003 on State Finances, Law 1/2004 on the State Treasury and Law 15/2004 on the Audit of State Finances.

¹³For a discussion of the major problems faced in reforming the present civil service, see McLeod (2005: 152–6). For previous attempts at such reform, see Booth (2005: 213–5).