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Economics: Case Study: Growing Pains in Indonesia


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  • Type: Video Tutorial
  • Length: 11:46
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 125 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: Productivity and Growth (12 lessons, $18.81)
Economics: Emerging Economies (4 lessons, $6.93)

This video lesson on economics looks at growing pains in Indonesia. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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Why is it that some economies seem to thrive whenever they are buffeted by competition from abroad, whereas other economies seem to fall apart when international economic events bear down on them? Consider the case of Indonesia, widely regarded as a success story in the 1970's and 80's. But then, in 1997, pressure from outside the economy forced Indonesia to devalue its currency and everything fell apart within the space of a week. What was going on? What made the Indonesian economy so fragile and what are its prospects for the future?
Let's consider first how Indonesia got into the state that it was in. In the 1970's, 80's and early 1990's, the gross domestic product per capita in Indonesia increased at a rate of about 7% a year, so that output increased four-fold in that country in a space of one generation. This is an incredible increase in economic output and one of the fastest reductions in poverty anywhere in the world in history. Not only that, but this economic miracle was spread pretty evenly over the population. In the early 1970's, about 60% of Indonesians lived below the poverty line, and yet by 1996, only 11% did. So the economic benefits were spread throughout the population and the society appeared to be relatively stable. And yet, in 1997, events in East Asia put Indonesia's economy under extreme pressure. In Thailand and Malaysia, troubles forced those economies to devalue their currency. And as their currencies depreciated, Indonesia had to depreciate its own currency, or else risk losing all of its export markets. It couldn't be competitive with other Asian economies unless it followed suit and also depreciated. What was happening then in Indonesia was that the price of imported goods was skyrocketing. Bringing imports into the country became very, very expensive overnight, which put pressure on any businesses in Indonesia that depended on imported capital or imported raw materials. Not only that, but investors, fearing that the Indonesian rupia would further depreciate, very quickly tried to convert their investments from rupia into dollars or yen or some other more stable currency. So as everyone began selling off all of their Indonesian investments, capital was hard to get in Indonesia. Interest rates went through the roof and businesses found themselves closing for lack of capital and for lack of export markets. Very quickly, lots of poor Indonesians lost their jobs and output began contracting. Economic output in the country, which had grown by 8% in 1996 and 5% in 1997, began contracting at a rate of about 15% a year in 1998. The economy was actually shrinking. This balloon that had been blowing up began to deflate.
Well, very quickly the crisis turned from being an economic one to being a political one. A drought that arrived in 1997, right on the heels of the devaluation of the currency made food hard to get. So not only were people poor and unemployed, they were now hungry on top of this. And Indonesians took to the streets in 1998, rioting for political reform. Their dictator, Suharto, who had ruled the country since the late 1960's, suddenly found himself faced with calls for resignation and overthrow, and there was even concern that the military would turn on him, because of popular unrest. So a popular election brought to power someone who was widely believed to be, again, someone under the influence of Suharto. So it appeared that there was no real change and discontent continued through 1998.
How did Indonesia get in this situation? How could a depreciation of their currency so quickly turn everything to dirt? Well, consider things that made Indonesia successful to start with. The first was rapid technological advance. Green revolution technology, which made agriculture more productive and other imported capital goods and technologies made Indonesia industrially productive as well as in the 70's, 80's and 90's. So the quick adaptation of technologies that had been developed other placed made Indonesia well positioned for industrial output increase and agricultural increases. Also, the government maintained prudent macroeconomic policies, rather than running budget deficits that created instability, they maintained budget balance, which typically kept interest rates low and made capital available to other sectors of the economy, because the government wasn't using all of Indonesia's savings. So good macroeconomic policy was also a key to the success early on. And a third thing was trade liberalization. In general, there was a dismantling of regulation of the economy during this period, and imports and exports flowed freely and businesses could start and compete with one another in an attempt to get profits. So the Indonesian economy was relatively deregulated during this period. So these three things would tend to combine to make Indonesia a good candidate for success economically.
However, there was trouble during this time as well. Because the economy was growing so rapidly, the banking system was expanding very, very quickly. And the banking system was not finding itself on very, very stable foundations. In fact, it was quite corrupt. There were people within the banking system that were directing capital not necessarily to the most productive projects, but to the projects that most benefited friends of the bankers. And this corruption then created a rotten foundation for the economy, because as soon as some of the bank loans began to go bad, the banking system found itself in trouble and vulnerable to runs on the bank. And once the banking system starts to collapse, then businesses lose capital and everything can go bad very quickly. So a weak banking system was being set up as the economy grew faster than a stable banking system could spread out to support it.
A second problem with the Indonesian economy was corruption at the very highest levels. The Suharto family, the family of the dictator, began to play a larger and larger role in the government, actually owning large shares of businesses, directing the allocation of capital and making profit off of crony loans, loans to friends rather than loans to the most productive projects. So as the Suharto family began to direct the economy, the benefits of the market allocation were lost. Rather than going to the highest bidder, capital began to go to friends of the dictator. And as the dictator began to play a larger and larger role in the economy for his own enrichment, then the economy was on shaky ground, because all it took was competition from abroad or a devaluation of the currency to set in motion a chain reaction, and one flimsy institution after another would fall.
Another problem was all of the capital that was in Indonesia, a very, very large chunk of it was coming from abroad. There was not a great deal of domestic savings relative to the amount of investment that was being done in the economy. Therefore, foreigners who became fearful that the rupia would depreciate would be very quick to take their money out of the economy. Not only was it foreign capital, but it was short-term capital, capital that people could get out quickly if they wanted. So this is typically going to be a problem for a rapidly growing country; that is, if a lot of finance is coming in from abroad, it can flow out just as quickly as it flowed in. And one of the things that will lead foreign capital to flow out of an economy is a risk of depreciation of that country's currency. People want to get their money out before it loses value.
Well, all of this came to a head in 1997. In 1997, in the summer when Thailand and Malaysia first had their trouble, then Indonesia found itself in the position of being forced to depreciate its currency. It devalued its currency rather than trying to support a stronger rupia by spending foreign exchange reserves, because they knew that was a losing battle. So one thing that Indonesia did right was rather than spending all their reserves, they quickly depreciated their currency. On the other hand, that immediately set off all of the problems we've discussed: rapid inflation, capital flight out of the country. And then, on top of that, the banks began to find themselves in the situation that no one could repay their loans. Therefore, the banking system began to close down and the money supply began to shrink. And one problem after another popped up out of this crisis.
Well, as economists look back on it, they say, first of all, that the corruption that was inherent in the system should have been a warning to all of us. Why were foreign investors pouring so much money into this economy when so much of it was going to corrupt investments? In some cases, people were being bribed and paid on the side and the allocation mechanism wasn't working properly. But people were still making money, because of the corruption that was going on. And yet, in the end, it all came home to roost whenever the value in the economy was destroyed by the depreciation and the events that followed.
Then the International Monetary Fund was invited in to try to help sort out the mess. But, by most measures, their intervention was a failure. It was too late and it was too little. The money that was promised didn't come in time. The Fund closed down banks too quickly in some cases, even some banks that might have been able to struggle along, while other banks were failing. There was a lot of criticism of the International Monetary Fund's intervention and perhaps they actually made things worse than better. Not that the International Monetary Fund doesn't often help countries through periods of transition, but in this case it appears that their actions were relatively unsuccessful and may have exacerbated the problem.
So then there is the dictator himself, who seems to have made the problem go on and on by refusing to leave office until absolutely forced to do so by riots and strikes and all kinds of turmoil. What happens then in this case, when the political turmoil breaks out, is everyone starts looking for a scapegoat and the dictator stirred the populous up, as frequently happens, against the ethnic Chinese in that country, who were the people who, in most cases, running retail establishments and undertaking finance. So when the people who have the business acumen and the experience and skill and connections to make your economy work are being attacked and becoming the victims of crimes of prejudice, then that just makes things worse on top of that.
Nowadays, the situation in Indonesia has improved somewhat, largely due to a boom in the world economy. Export markets have been restored, some measure of stability has been restored, they have made a transition to a government that is no longer a dictatorship, but relatively popularly elected. And so the prospects for Indonesia have improved. But the country still has a long way to go. Like many of the countries of East Asia, their economic system, particularly their banking system, has been directed not so much by competition to officially allocate capital, but rather by friendship connections and, in some cases, just blatant corruption. And until the banking system is on firm foundation and until the businesses are competing for capital that should go to those who have the best use of it, then we're not building a strong foundation for an economy that can endure the kind of shocks that buffeted Indonesia 1997. If your institutions aren't being driven by efficiency, by allocation towards the creation of value, then, when something happens like this from abroad that forces you into a crisis, you can expect all the turmoil that you got in Indonesia. Indonesia had unusually bad luck, but this unusually bad luck exposed the unusual extent of the corruption in the economy.
Productivity and Growth
Emerging Economies
Case Study: Growing Pains in Indonesia Page [3 of 3]

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