While the Bouteflika government is enjoying a heavy weight on Algeria's political scene, the country's new economic problems are still the old ones. This article looks at three main paradoxes that may have marked the launching path for Algeria's severe economic woes. It may be simplistic to say, but the fact is that, Bouteflika's success does not depend on his political skills only--much more on the ability to fix the economy. More precisely, Algeria needs to rethink its IMF-sponsored strategy, the labour market and its paradoxical spending.

The IMF

When Algeria declared, in the late 1980s, that Socialist planning had to be scrapped and abandoned, the international community responded with gratitude, and the IMF rushed for help. Although some interest groups in the country felt embarrassed at the time, the mood has since then changed: It is now firmly believed that Algeria's ultimate solution must lie in the hands of a market economy.

While this is certainly a healthy thought, it dangerously obscures the fact that long-term policy prescriptions cannot be traded for short-term solutions. The fact is that Algeria may have been following a simple macroeconomic stabilization program that, indeed, is too simple to generate long-term prosperity. Fighting inflation for its own sake, for example, does not ensure the existence of a leading manufacturing sector¾the engine of sustainable development.

What Algeria has been doing since the collapse of world oil prices in 1986 is to manipulate government spending and money supply. While these might help stabilize the economy in the short run (by, for example, reducing the inflation rate), they by no means can be claimed to provide long-term solutions to fundamental economic problems.

Standard economic theory predicts that, as GDP declines, the inflation rate increases. The reason is straightforward: As aggregate demand runs ahead of aggregate supply, people carry extra money for which there is no supply of goods and services.

This explains Algeria's situation. As total output decreased from 5.5 percent in 1980-85 to less than 1 percent in 1986-91, the inflation rate increased. This, as measured by the annual change in Consumer Price Index (CPI), increased from 8 percent in 1980-85 to over 11 percent in 1986-91.

This, however, is misleading for two main reasons. First, it hides the extremes: In 1991, for example, the inflation rate as measured by the change in CPI was over 20 percent, compared with only about 5 percent in 1983. Second, the GDP price index tells a better story for that it is wider in coverage. Thus, this increased from about 5 percent in 1980-85 to 18 percent in 1986-91. But, as for the CPI, the GDP price index also hides the extremes. In 1991, the increase in the GDP price index was about 40 percent, compared with only about 1 percent in 1982.

Algeria's policy response could not be different from that of the IMF. The government used tight fiscal and monetary policies, thus reducing both general spending and the money supply. The former decreased from about 5 percent in 1980-85 to less than 3 percent in 1986-91, while the latter declined from over 10 percent in 1980-85 to -2 percent in 1986-91.

Unfortunately, the success of such a policy has been very limited. First, it had political repercussions for that it cost Mr. Bendjedid his 1991 elections. Second, ten years after the collapse of the world oil price in 1986, the inflation rate was still unacceptably high. Thus, in 1996, the inflation rate (as measured by the annual change in the CPI) was as high as 19 percent¾or 23 percent if measured by the change in the GDP price index.

Such tight fiscal and monetary policies did not solve the high unemployment problem either. At the eve of the 1989 reforms, the official unemployment rate in the non-agricultural sector stood at 19 percent; in 1996, this was about 30 percent.

The economic repercussions of high unemployment could not be underestimated. It is estimated that this costs for Algeria for the period 1986-91 alone was as much as AD100 billion.

The inflation problem cost the nation a fortune too. It eroded the purchasing power of thousands of workers, especially those with fixed salaries. Thus, private consumption decreased by 3 percent in the period 1987-97, compared with a growth rate of more than 7 percent for 1976-86. Similarly, GDP per capita, a rough measure of a person's living standard, declined by more than 2 percent in 1987-97.

While the above analysis points out to the fact that Algeria's stabilisation measures for the 1980s and 1990s enjoyed only a very limited success, recent events reinforce this belief. In 1998, for example, the external environment worsened as the average oil export price fell by 33 percent. As a result, the fiscal balance that was finally achieved in 1997 moved from a surplus of 2.4 percent of GDP to a deficit of 7 percent of GDP. Similarly, the external current account deteriorated sharply from a surplus of 7 percent of GDP in 1997 to a deficit of about 2 percent of GDP.

Despite a modest recovery in world oil and gas prices, Algeria's external position has continued to be adversely affected. For the year ending 30 June 1999, receipts from oil and gas sales are expected to be lower by at least US$2 billion, compared to the previous 12-month period.

Our expectations are such that the authorities will rush to curb domestic demand. To improve the external current account and fiscal deficits, they will also allow the dinar to depreciate. Furthermore, public expenditures will be reduced, and a tight wage and monetary policy will be pursued.

While our hope is that they will work, our analysis suggests that their success is likely to be limited. Algeria's problems, in our judgement, require long-term solutions: Increasing aggregate supply, not curbing aggregate demand. There are several ways of doing this, but the most important of these include (i) increasing the size of the manufacturing sector, (ii) utilising the existing reservoir of human resources, and (iii) investing in technology.

It is time to learn that Algeria's dependency on oil proceeds for economic development does not work. One must remember that the hydrocarbons sector accounts for a quarter of the country's GDP. This means that GDP per capita would have decreased by at least 25 percent in 1997, amounting to only about US$ 1000 (instead of the actual US$ 1500), which amounts to only about US$2.5 per day.

But this, in itself, is an optimistic estimation. The oil sector contributes more than half of government revenues and virtually all export receipts. This implies that if oil runs out or that a cheaper substitute is found, exports will virtually be zero. Since Algerians' living standards depend almost solely on oil proceeds, the implications for the long run are such that a good approximation of GDP per capita would be about US$2.5 per month.

The Labour Market

The Pre-1986 Paradox: High Wages and Low Productivity

Algeria's labour market is a field for research. Unlike predictions by economic theory, increases in real wages in Algeria are not determined by real productivity growth. Our estimations show that while productivity growth was 1 percent in the period 1977-85, real wages increased by about 8 percent. This is equivalent to saying that real wages in Algeria increase by 800 percent for each 100 percent increase in productivity levels.

This, indeed, raises a mystery in macro-economics theory for it does not happen even in very high income countries. For example, in the period 1980-92, while US productivity growth increased by 1.7 percent, American workers had their real wages increased by only 0.5 percent. For South Korea, an increase in real wage by 8 percent, i.e. similar to that of Algeria, required an increase in real productivity by 8.5 percent.

The Post-1986 Paradox: Low Wages and High Unemployment

Macroeconomics theory predicts that, as wages decrease, the quantity of labour employed increases. The reason is that as wages decline, costs of production decrease, so companies find it more attractive to increase production. This increase in output requires an increase in the labour employed.

However, Algeria's labour market does not obey such a rule. In the period 1986-91, although real wages, nominal deflated by the GDP price index, declined by 1.5 percent, the unemployment rate increased from about 14 percent in 1986 to 22 percent in 1991. But this is the official rate. Our estimates suggest that this may have been underestimated by about two to three times. Thus, in 1991, the unemployment rate was about 62 percent, compared with 32 percent in 1986.

There are several reasons as to why Algeria's labour market raises this paradox in macro-economics theory. First, the number of workers needed by companies has never been determined by supply and demand forces. Government intervention in the labour market has been such that labour demand is determined by the capacity of the public sector to absorb workers even if their contribution to economic growth was negative. This is the well-known phenomenon of "disguised" unemployment, which is a striking characteristic of developing countries.

Second, Algeria's unemployment rate is more determined by external factors than internal ones. More precisely, the number of Algeria's workers seems to have been a function of world oil prices. Prior to the 1986 world oil price collapse, Algeria had little difficulties financing its public investment. As a result, job creation was relatively high. With the collapse of OPEC in the second half of the 1980s, this has no longer been the case.

Another contributing factor is, of course, the recent drive towards a market economy. Since the IMF was behind the initiative, this can also be regarded as an external factor. As has been demonstrated in the 1999 February issue of the North Africa Journal, at least 30 percent of Algeria's unemployment rate in the post-reform period was the result of economic reforms.

The transition to a market economy has decreased Algeria's employment through various channels. Before 1989, most employment was in the state sector¾the sector composed of the large firms producing under the central plan. The expectation was that the initial effects of the transition would be to reduce the demand for labour in the state sector but to substantially increase it in the private sector. Unfortunately, the net effect was the opposite: a sharp decrease in employment.

The reasons are not hard to find. First, many firms experienced sharp decreases in demand. With price liberalisation, many of their goods they produced were no longer in demand. Second, contrary to what the IMF and the government expected, demand did not shift to goods produced by the new private sector. Hence there has not been an increase in private employment sufficient to offset the decrease in state employment. This is because the private sector could not grow fast enough. One reason is that production of new goods requires capital and expertise, and both were absent at the beginning of the transition. Another is that the banking system lacked the expertise to make loans so what would be the new entrepreneurs could not obtain credit to buy new capital.

More importantly, because entrepreneurial skills were not taught to be very useful under central planning, most would-be entrepreneurs lacked the knowledge and the skills needed to create and run new firms. As a result, the increase in employment in the private sector was insufficient to offset the decrease in employment in the state sector.

The above situation has serious implications. First, Algerian workers today are worse off than workers in previous generations (when oil prices were relatively high). From 1986 to 1991, real wages grew at a negative average rate of -1.5 percent. This may not seem large, but accumulated over many years, even a small change in a growth rate is significant. If wages had grown at the same rate since between 1986 and 1991 as they did for the period 1977-85, workers earnings would have been 20 to 40 percent higher than they actually were.

Second, there are economic costs attached to unemployment. These can be measured by estimating the economy's potential GDP, or what GDP would have been without world oil price collapse and economic reforms. The gap between actual GDP and potential GDP is then the Algerian Dinar (AD) value of final goods and services not produced because there was unemployment.

These estimates for Algeria were striking. It was found that, in the period 1986-91 alone, Algeria has lost more than AD100 billion due to employment decline. This loss is undoubtedly underestimated for that prior to 1986, the official unemployment rate was already high, averaging 16 percent for the period 1977-85. What was has been taken into account was only the unemployment rate resulting from the collapse of OPEC and the introduction of structural adjustment programmes in the late 1980s.

Modern economic research has shown that, physical capital, human capital, and technological knowledge are the ultimate sources of most of the differences in productivity, wages, and standards of living among countries. When workers work with a larger quantity of equipment and structures, they are more educated, and have access to more sophisticated technologies, they produce a lot more. This is the way Algeria should prosper.

Government Spending

Governments claim victory when the budget is balanced. In Algeria's recent history, there has even been a surplus. Yet, this rises no mystery for at least we know it is an IMF requirement. But what indeed rises the mystery is the way the government spends its tax revenues. Our study shows that, for every US$1.00 in new spending, only US$0.04 goes to the economy. The remaining 96 cents is spent on general and social services, in addition to subsidies and interest on public debt.

Figure 1 Algeria's government spending pattern

The mystery deepens when one looks at the details. First, spending on national defense (an element in the general services category) alone turned out to be 2.5 times higher than that on economic services as a whole. It is found that, for every US$1.00 in new spending, more than 10 cents goes to national defense, as opposed to only 4 cents for economic services. While spending on national defense is ranked third, that on industry, for example, is nineteenth.

Second, spending on higher education and research is minimal. It is estimated that, for every US$1.00 in new spending, only 0.64 cents is spent on this category. A striking finding is that spending on public debt interest is more than five times higher than spending on education, research and development.

Third, spending on housing and construction is negligible. This ranks 24th. Our estimates suggest that, for every US$1.00 in new spending, only 0.11 cents is spent on housing and construction. Given the fact that housing has always been at a crisis point in Algeria, this pattern of spending seems paradoxical.

On the other hand, spending on employment and social affairs is ranked amongst the highest top ten. This study's estimates suggest that, for every US$1.00 in new spending, about 1.7 cents goes to job creation. This is more than 15 times higher than spending on housing and construction. For some, this may be justified given the recent 30 percent official unemployment rate. Indeed, this action is justified by entirely respectable macro-economic theory. The so-called Keynesian paradigm, quite fashionable a few decades ago, urged that government increase aggregate demand so as to increase output and employment. The flaw in this argument, however, is that, the Keynesian prescription only works in a depression where there is generalized excess capacity. Algeria's situation, on the other hand, is a lack of productive capacity, which explains why all job creation programs have failed so far. Thus government's role must be to build capacity by focusing its very limited funds for the most productive projects.

However, there is good news. The most important of these is that, spending on primary and secondary education is reasonably high; thanks to the policy of free education. The estimates suggest that for every US$1.00 in new spending, more than 20 cents goes to this category. In other words, spending on primary and secondary education is ranked second, after spending on 'other common services'.

Spending on health is also important, although less remarkable. The estimates suggest that, for every US$1.00 in new government spending, about 6 cents is spent on health. This represents about 28 percent of the increase in spending on primary and secondary education.

There is no doubt that spending on health and education is very important. This is because it has wide implications for long-term economic growth. It is common sense that more educated and healthy workers will contribute more to economic development.

This pattern of Algeria's government spending poses at least three main problems. The first is that, since government deficit is simply expenditures minus tax revenues, there is apparently the question of where to get these revenues when oil runs out. It is estimated that, for every US$1.00 in new spending, at least 75 cents comes from taxes on oil exports.

The second has to do with the important distinction between spending on current consumption and spending on investment goods. It turned out that current consumption has indeed occurred at the expense of government investment on public capital. This has been strictly the case in the 1980s when government investment expenditure as a share of GDP declined while government current consumption expenditures have continued to increase.

Figure 2 Current versus capital expenditures: 1972 to 1989

This reallocation of spending priorities must be of a great concern because the decline in investment spending is associated with a decline in the stock of public capital and infrastructure. Such a decline will certainly hamper the efficiency of the private sector capital stock.

Finally, for all this increase in spending, only 4 percent goes to economic services. This shows that economic development in Algeria has always received the least priority. If this continues, the prospects for a modern, industrialized, first world economy will be slim. If there is a task for the new elected president, it must be to both explain and resolve such a spending paradox. This is important for that, it may well have been the launching path for the current political turmoil, social unrest and economic bottlenecks.