Macroeconomic policy in conflict-affected contexts

Conflict-affected situations are often characterized by challenging security, political and economic environments. Capital flight and inflation can emaciate financial markets, while volatile financial flows and diminishing money demand can put pressure on exchange rates. Supply-side shocks in economies dominated by agriculture or natural resource exports present policymakers with trade-offs between inflation and output objectives. Large informal sectors can weaken monetary policy transmission mechanisms and provide for a limited tax base. Also, because infrastructure and public services may be limited, institutional, administrative, technological and statistical capacities can be weak. 

As a team of economists, political scientists and data scientists, The Deetken Group has worked with the United Nations and World Bank to explore the relationship between macroeconomic policies and fragility in countries affected by violent conflict.  We wanted to know what the literature and the experts were saying about how to “do macroeconomics differently” to reduce or mitigate fragility in conflict-affected contexts.

Our report centered around three macroeconomic policy categories: natural resource management, tax policy, and monetary and exchange rate policy.  After reviewing over 100 sources and conducting a dozen interviews with experts, we identified three key messages on macroeconomic policy in conflict-affected contexts.

Message 1: If well-managed, natural resource revenues can have real peace-related benefits in conflict-affected contexts.
Disputes over access to, and distribution of, the benefits from natural resources is a common factor in violent conflict. As such, in many conflict contexts, the establishment of an effective revenue-sharing regime is essential. The effectiveness of these regimes in addressing conflict mechanisms depends on a variety of factors: the type of resource and its role in the conflict; the strength of domestic institutions and the regulatory / legal environment in which they operate; the internal and external power relations, interests and incentives at play; and regional dynamics and international markets.  The evidence suggests that the establishment of mechanisms to combat corruption and a commitment to transparency are two essential elements for achieving the peace-related benefits resulting from effective natural resource management. For example, although not without its challenges, the Timor-Leste Petroleum Fund, established in 2005, is considered a relatively effective revenue management arrangement. It was established to manage petroleum resources, stabilize the flow of revenue, and mitigate risks associated with oil price volatility.  The fund has successfully responded to financial shocks and has accumulated large savings.  Its relative success is attributed to relatively high degrees of transparency and because it is subject to democratic checks and balances.

Message 2: Well-designed tax policy can contribute to state-building, improved governance, peacebuilding, and political and economic stability in conflict-affected contexts.
Conflict-affected contexts face a unique set of challenges with respect to taxation. These can include: a real or perceived lack of legitimacy; a lack of trust and confidence in the state and/or other groups in society; a lack of political consensus and/or historical precedent around who should be taxed and how; weak technical, technological and statistical capacities; large informal and agricultural sectors; a contracted tax base; and a poor record of redistribution through the tax system. While there is no consensus on what would constitute an ideal tax regime in conflict-affected contexts, the evidence[1] suggests that policymakers in conflict-affected contexts should consider impacts on revenue generation, (in)equality, and state legitimacy, at minimum
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Message 3: Policymakers should focus on maintaining macro-fiscal stability in conflict-affected contexts.
Fiscal shocks can exacerbate fragility in conflict-affected contexts. Accordingly, any government spending reductions should be designed and timed to mitigate impacts. In the context of subsidy reform, several elements are critical to success, including compensation and mitigation mechanisms; careful timing and pacing of reform; and an effective communication strategy that ensures the objectives of the reform are understood. The flagship study, Pathways for Peace,  discusses these aspects of effective reform while noting the political difficulty and fiscal risks demonstrated by cases of energy subsidy reform reversal in Jordan (2011), Indonesia (2012), and Thailand (2013).[2]
 
Reigning in elevated inflation is a standard policy recommendation. Further, it has been argued that declining inflation is associated with building resilience. However, a higher rate of inflation may be acceptable in conflict-affected contexts so long as it is stable and hyper-inflationary episodes are avoided.
Recent evidence[3] suggests that fixed and managed exchange rate regimes may be preferable to free-floating currencies in conflict-affected contexts. The evidence for this claim adds to the argument that the effect of policies on macroeconomic stability should be prioritized in decision making in conflict-affected contexts.