Joseph Stiglitz and the World Bank: The Rebel Within available in Hardcover
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About the Author
Joseph E. Stiglitz is the former Chief Economist of the World Bank. He is currently Professor of Economics at Columbia University and Nobel Laureate, to NDTV
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Joseph Stiglitz and the World Bank The Rebel Within
By Joseph Stiglitz, Ha-Joon Chang
Wimbledon Publishing CompanyCopyright © 2001 Wimbledon Publishing Company
All rights reserved.
More Instruments and Broader Goals: Moving Toward the Post-Washington Consensus
The 1998 WIDER Annual Lecture Helsinki, January 1998
I would like to discuss improvements in our understanding of economic development, in particular the emergence of what is sometimes called the "post-Washington consensus". My remarks elaborate on two themes. The first is that we have come to a better understanding of what makes markets work well. The Washington consensus held that good economic performance required liberalized trade, macroeconomic stability and getting prices right (see Williamson, 1990). Once the government dealt with these issues – essentially, once the government "got out of the way" – private markets would allocate resources efficiently and generate robust growth. To be sure, all of these are important for markets to work well: it is very difficult for investors to make good decisions when inflation is running at 100 per cent a year and highly variable. But the policies advanced by the Washington consensus are not complete, and they are sometimes misguided. Making markets work requires more than just low inflation; it requires sound financial regulation, competition policy, and policies to facilitate the transfer of technology and to encourage transparency, to cite some fundamental issues neglected by the Washington consensus.
Our understanding of the instruments to promote well-functioning markets has also improved, and we have broadened the objectives of development to include other goals, such as sustainable development, egalitarian development and democratic development. An important part of development today is seeking complementary strategies that advance these goals simultaneously. In our search for these policies, however, we should not ignore the inevitable tradeoffs. This is the second theme I will address.
SOME LESSONS OF THE EAST ASIAN FINANCIAL CRISIS
Before discussing these themes, I would like to address the implications of the current East Asian crisis for our thinking about development. Observation of the successful, some even say miraculous, East Asian development was one of the motivations for moving beyond the Washington consensus. After all, here was a regional cluster of countries that had not closely followed the Washington consensus prescriptions but had somehow managed the most successful development in history. To be sure, many of their policies – such as low inflation and fiscal prudence – were perfectly in line with the Washington consensus. Several aspects of their strategy, such as an emphasis on egalitarian policies, while not at odds with the Washington consensus, were not emphasized by it. Their industrial policy, designed to close the technological gap between them and the more advanced countries, was actually contrary to the spirit of the Washington consensus. These observations were the basis for the World Bank's East Asian Miracle study (World Bank, 1993), and it stimulated the recent rethinking of the role of the state in economic development.
Since the financial crisis the East Asian economies have been widely condemned for their misguided economic policies, which are seen as responsible for the mess in which those economies find themselves today. Some ideologues have taken advantage of the current problems in East Asia to suggest that the system of active state intervention is the root of the problem. They point to the government-directed loans and the cozy relations between the government and the large chaebol in the Republic of Korea. In doing so, they overlook the successes of the past three decades, to which the government, despite occasional mistakes, has certainly contributed. These achievements, which include not only large increases in per capita GDP but also increases in life expectancy, the extension of education and a dramatic reduction in poverty, are real and will prove more lasting than the current financial turmoil.
Even when the governments directly undertook actions themselves, they had notable achievements. The fact that they created the most efficient steel plants in the world challenges the privatization ideologues who suggested that such successes are at best a fluke, and at worst impossible. Nevertheless, I agree that, in general, government should focus on what it alone can do and leave the production of commodities like steel to the private sector. But the heart of the current problem in most cases is not that government has done too much in every area but that it has done too little in some areas. In Thailand the problem was not that the government directed investments into real estate; it was that government regulators failed to halt it. Similarly, the Republic of Korea suffered from problems including overlending to companies with excessively high leverage and weak corporate governance. The fault is not that the government misdirected credit – the fact the current turmoil was precipitated by loans by so many US, European and Japanese banks suggest that market entities also may have seriously misdirected credit. Instead the problem was the government's lack of action, the fact that the government underestimated the importance of financial regulation and corporate governance.
The current crisis in East Asia is not a refutation of the East Asian miracle. The basic facts remain: no other region in the world has ever had incomes rise so dramatically and seen so many people move out of poverty in such a short time. The more dogmatic versions of the Washington consensus fail to provide the right framework for understanding either the success of the East Asian economies or their current troubles. Responses to East Asia's crisis grounded in these views of the world are likely to be, at best, badly flawed and, at worst, counterproductive.
MAKING MARKETS WORK BETTER
The Washington consensus was catalyzed by the experience of Latin American countries in the 1980s. At the time markets in the region were not functioning well, partly the result of dysfunctional public policies. GNP declined for three consecutive years. Budget deficits were very high – some were in the range of five to ten per cent of GDP – and the spending underlying them was being used not so much for productive investments as for subsidies to the huge and inefficient state sector. With strong curbs on imports and relatively little emphasis on exports, firms had insufficient incentives to increase efficiency or maintain international quality standards. At first deficits were financed by borrowing – including very heavy borrowing from abroad. Bankers trying to recycle petrodollars were quick to lend and low real interest rates made borrowing very attractive, even for low-return investments. After 1980, though, real interest rate increases in the United States restricted continued borrowing and raised the burden of interest payments, forcing many countries to turn to seignorage to finance the gap between the continued high level of public spending (augmented by soaring interest payments) and the shrinking tax base. The result was very high and extremely variable inflation. In this environment money became a much costlier means of exchange, economic behavior was diverted toward protecting value rather than making productive investments, and the relative price variability induced by the high inflation undermined one of the primary functions of the price system: conveying information.
The so-called "Washington consensus" of US economic officials, the International Monetary Fund (IMF) and the World Bank was formed in the midst of these serious problems. Now is a good time to reexamine this consensus. Many countries, such as Argentina and Brazil, have pursued successful stabilizations; the challenges they face are in designing the second generation of reforms. Still other countries have always had relatively good policies or face problems quite different from those of Latin America. East Asian governments, for instance have been running budget surpluses; inflation is low and, before the devaluations, was falling in many countries (see figures 1 and 2). The origins of the current financial crises lie elsewhere and their solutions will not be found in the Washington consensus.
The focus on inflation – the central macroeconomic malady of the Latin American countries, which provided the backdrop for the Washington consensus – has led to macroeconomic policies that may not be the most conducive for long-term economic growth, and it has detracted attention from other major sources of macro-instability, namely, weak financial sectors. In the case of financial markets the focus on freeing up markets may have had the perverse effect of contributing to macroeconomic instability by weakening the financial sector. More broadly, in focusing on trade liberalization, deregulation, and privatization, policymakers ignored other important ingredients, most notably competition, that are required to make an effective market economy and which may be at least as important as the standard economic prescriptions in determining long-term economic success.
Other essential ingredients were also left out or underemphasized by the Washington consensus. One – education – has been widely recognized within the development community; others, such as the improvement of technology, may not have received the attention they deserve.
The success of the Washington consensus as an intellectual doctrine rests on its simplicity: its policy recommendations could be administered by economists using little more than simple accounting frameworks. A few economic indicators – inflation, money supply growth, interest rates, budget and trade deficits – could serve as the basis for a set of policy recommendations. Indeed, in some cases economists would fly into a country, look at and attempt to verify these data, and make macroeconomic recommendations for policy reforms, all in the space of a couple of weeks.
There are important advantages to the Washington consensus approach to policy advice. It focuses on issues of first-order importance, it sets up an easily reproducible framework which can be used by a large organization worried about recommendations depending on particular individuals' viewpoints, and it is frank about limiting itself only to establishing the prerequisites for development. But the Washington consensus does not offer answers to every important question in development.
In contrast, the ideas that I present here are, unfortunately, not so simple. They are not easy to articulate as dogma nor to implement as policy. There are no easy-to-read thermometers of the economy's health, and worse still, there may be trade-offs, in which economists, especially outside economists, should limit their role to describing consequences of alternative policies. The political process may actually have an important say in the choices of economic direction. Economic policy may not be just a matter for technical experts! These conflicts become all the more important when we come to broaden the objectives, in the final part of this talk.
This part of the paper focuses on enhancing the efficiency of the economy. I will discuss macro-stability and liberalization – two sets of issues about which the Washington consensus was concerned – as well as financial sector reform, the government's role as a complement to the private sector, and improving the state's effectiveness – issues that were not included in the consensus. I shall argue that the Washington consensus' messages in the two core areas are at best incomplete and at worse misguided. While macro-stability is important, for example, inflation is not always its most essential component. Trade liberalization and privatization are key parts of sound macro-economic policies, but they are not ends in themselves. They are means to the end of a less distorted, more competitive, more efficient marketplace and must be complemented by effective regulation and competition policies.
ACHIEVING MACROECONOMIC STABILITY
Probably the most important policy prescription of the stabilization packages promoted by the Washington consensus was controlling inflation. The argument for aggressive, preemptive strikes against inflation is based on three premises. The most fundamental is that inflation is costly and should therefore be averted or lowered. The second premise is that once inflation starts to rise it has a tendency to accelerate out of control. This belief provides a strong motivation for preemptive strikes against inflation, with the risk of an increase in inflation being weighed far more heavily than the risk of adverse effects on output and unemployment. The third premise is that increases in inflation are very costly to reverse. This line of thought implies that even if maintaining low unemployment were valued more highly than maintaining low inflation, steps would still be taken to keep inflation from increasing today in order to avoid having to induce large recessions to bring the inflation rate down later on. All three of these premises can be tested empirically.
I have discussed this evidence in more detail elsewhere (Stiglitz 1997a). Here I would like to summarize briefly. The evidence has shown only that high inflation is costly. Bruno and Easterly (1996) found that when countries cross the threshold of 40 per cent annual inflation, they fall into a high-inflation/low-growth trap. Below that level, however, there is little evidence that inflation is costly. Barro (1997) and Fischer (1993) also confirm that high inflation is, on average, deleterious for growth, but they, too, fail to find any evidence that low levels of inflation are costly. Fischer finds the same results for the variability of inflation. Recent research by Akerlof, Dickens, and Perry (1996) suggests that low levels of inflation may even improve economic performance relative to what it would have been with zero inflation.
The evidence on the accelerationist hypothesis (also known as "letting the genie out of the bottle", the "slippery slope", or the "precipice theory") is unambiguous: there is no indication that the increase in the inflation rate is related to past increases in inflation. Evidence on reversing inflation suggests that the Phillips curve may be concave and that the costs of reducing inflation may thus be smaller than the benefits incurred when inflation is rising.
In my view the conclusion to be drawn from this research is that controlling high and medium-rate inflation should be a fundamental policy priority but that pushing low inflation even lower is not likely to significantly improve the functioning of markets.
In 1995 more than half the countries in the developing world had inflation rates of less than 15 per cent a year (figure 3). For these 71 countries controlling inflation should not be an overarching priority. Controlling inflation is probably an important component of stabilization and reform in the 25 countries, almost all of them in Africa, Eastern Europe and the former Soviet Union, with inflation rates of more than 40 per cent a year. The single-minded focus on inflation may not only distort economic policies – preventing the economy from living up to its full growth and output potentials – but also lead to institutional arrangements that reduce economic flexibility without gaining important growth benefits.
Managing the budget deficit and the current account deficit
A second component of macroeconomic stability has been reducing the size of government, the budget deficit and the current account deficit. I will return to the issue of the optimal size of government later; for now I would like to focus on the twin deficits. Much evidence shows that sustained, large budget deficits are deleterious to economic performance (Fischer, 1993; Easterly, Rodriguez and Schmidt-Hebbel 1994). The three methods of financing deficits all have drawbacks: internal finance raises domestic interest rates, external financing can be unsustainable, and money creation causes inflation.
Excerpted from Joseph Stiglitz and the World Bank The Rebel Within by Joseph Stiglitz, Ha-Joon Chang. Copyright © 2001 Wimbledon Publishing Company. Excerpted by permission of Wimbledon Publishing Company.
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Table of Contents
Commentary by Ha-Joon Chang; More Instruments and Broader Goals: Moving Toward the Post-Washington Consensus; Towards a New Paradigm for Development: Strategies, Policies and Processes; Redefining the Role of the State - What should it do? How should it do it? And how should these decisions be made? Whither Reform? - Ten Years of the Transition; The Role of International Financial Institutions in the Current Global Economy; Scan Globally, Reinvent Locally: Knowledge Infrastructure and the Localization of Knowledge; Participation and Development: Perspectives from the Comprehensive Development Paradigm; On Liberty, the Right to Know and Public Discourse: The Role of Transparency in Public Life; Democratic Development as the Fruit of Labor
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