Stiglitz on neoliberalism 1/3

[Robert Weissman <rob@essential.org>]

This is the first of three posts of a talk given by World Bank Chief
Economist Joseph Stiglitz. This is a long document, but very much worth
reading. In the talk, Stiglitz criticizes "the Washington Consensus," the
term he uses for the extreme neoliberalism that is characteristic of the
IMF and, in recent years to only a slightly lesser extent, of the World
Bank.

Thanks to Patrick Bond for the original post.

Robert Weissman
Essential Information			|   Internet:	rob@essential.org


MORE INSTRUMENTS AND BROADER GOALS: 
Moving Toward the Post-Washington
Consensus

Joseph Stiglitz, Senior Vice President and Chief Economist
The World Bank 
January 7, 1998
The 1998 WIDER Annual Lecture (Helsinki, Finland)

Today I would like to discuss improvements in our understanding of
economic development. In particular, I would like to use my lecture
today to discuss the emergence of what is sometimes called the
"Post-Washington Consensus". My remarks elaborate two themes. The
first theme is that we have come to a better understanding of what
makes markets work better.  The Washington Consensus  held that good
economic performance required liberalized trade, macroeconomic
stability, and getting prices right. Once the government handled these
issues - essentially, once the government "got out of the way" -
private markets would produce efficient allocations and growth. To be
sure, all of these are important for markets to work. It is very
difficult for investors to make good decisions when inflation is
running at 100 percent annually. But the policies advanced by the
Washington Consensus are hardly complete and 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 transparency, to name some
fundamental issues neglected by the Washington Consensus. At the same
time that we have improved our understanding of the instruments to
promote well-functioning markets, we have broadened the objectives of
development to include other goals like 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 will be the second
theme of my remarks today.

SOME LESSONS OF THE EAST ASIAN FINANCIAL CRISIS

Before discussing my two themes, I would like to address at the outset
one issue that is on many people's minds: the implications of the East
Asian crisis for our thinking about development. The 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 - like low inflation and fiscal prudence - were
perfectly in line with the Washington Consensus. But many, especially
in the financial sector, were not. This observation was the basis for
the World Bank's East Asian Miracle study (World Bank 1993) as well as
a stimulus for the recent rethinking of the role of the state in
economic development. Following the financial crisis, the East Asian
economies have gone from being cited for their remarkable success in
development to being widely condemned for the mess they find
themselves in today. Some ideologues have taken advantage of the
current problems besetting East Asia to suggest that the system of
active state intervention is the root of the problem. They refer to
the government directed loans and the cozy relations with the large
chaebol in Korea. In doing so, they forget the not inconsiderable
successes of the past three decades; to which the government, despite
its occasional mistakes, has certainly contributed. These achievements
are real, they are not a house of cards. No temporary financial
turmoil can or should detract from these achievements, which include
not only large increases in per capita GDP, but also extended life
spans, widespread education, and dramatically reduced poverty. Even
when the governments directly undertook actions themselves, they had
notable achievements: they created the most efficient steel plants,
contrary to privatization ideologues who suggested that such successes
are at best a fluke and at worst impossible. I agree that government
should focus on what it alone can do, and it should leave the
production of commodities like steel to the private sector. But I will
argue that the heart of the current problem in most cases is not that
government has done too much, but that it has done too little. In
Thailand, it was not that government directed the investments into
real estate; it was that government regulators failed to halt it.
Similarly, in Korea there was a big problem of lending to companies
with excessively high leverage as well as corporate governance issues
that include widespread cross=subsidization. The fault is not that the
government misdirected credit - in fact the problems faced by many US,
European and Japanese banks suggest that they also may have seriously
misdirected credit. Instead the problem was the government's lack of
action, the fact that it the government underestimated the importance
of financial regulation and corporate governance. The East Asian
crisis is not a refutation of the East Asian miracle. The more
dogmatic versions of the Washington Consensus does not provide the
right framework for understanding both the success of the East Asian
economies and their current troubles. Responses to East Asia's crisis
grounded in this view of the world are likely to be, at best, badly
flawed , an 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, the economies in the
region were clearly not functioning at all. GNP contracted for three
straight years in the early 1980s. The inability of markets to
function was clearly related to dysfunctional public policies. Budget
deficits were very high - many were in the range of 5 to 10 percent of
GDP - and the spending underlying them was not being used for
productive purposes but instead was diverted to subsidizing 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 borrowing from abroad. Real interest rates increases in the
United States prevented continued borrowing and increased the burden
of interest payments, forcing many countries to resort to seignorage
to finance the gap between the continued high level of public spending
and the continued 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. Amidst these serious problems the so-called "Washington
Consensus" of US economic officials, the International Monetary Fund
(IMF), and the World Bank, was formed. I think that now is a good time
for us to reexamine this consensus. Many countries, like Argentina and
Brazil, have pursued successful stabilizations and 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. In East Asia, for
instance, many governments have been running government surpluses and
inflations is low, and prior to the devaluations, was falling. (See
Charts 1 and 2). The origins of the current financial crises are
elsewhere and the solutions, like those of the problems of many other
countries, will not be found in the Washington Consensus either. I
will argue that 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 which
many not be the most conducive for long-term economic growth, and has
detracted attention from other major sources of macroeconomic
instability, namely weak financial sectors. The focus on freeing up
markets, in the case of financial market liberalization, may actually
have had a perverse effect, contributing to macro-instability through
weakening of the financial sector. More broadly, the focus on trade
liberalization, deregulation, and privatization ignored other
important ingredients required to make an effective market economy,
most notably competition: competition, in the end, may be as or more
important than these other ingredients in determining long-term
economic success. I will also argue that there were other ingredients
that are essential to economic growth that too were left out or
underemphasized by the Washington Consensus; one has been widely
recognized within the development community, education, but the
others, such as the improvement of technology, have perhaps not
received the attention they deserve. The success as an intellectual
doctrine of the Washington Consensus rests on its simplicity. Although
many of its proponents are very sophisticated and subtle in their
thinking, its policy recommendations could be administered by
economists using little more than simple accounting frameworks. They
could look at a few economic indicators - at inflation, money supply
growth, interest rates, budget and trade deficits - and form a picture
of the economy and a set of recommendations. Indeed, there have been
cases where economists 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, its sets up an easily
reproducible framework, and it is frank in its limitations to
establishing the prerequisites for development. But for these reasons,
the Washington Consensus does not offer the most important answers for
every question in development. Deluding ourselves into thinking that
it does can lead to misguided policies. In contrast, the ideas which I
wish to discuss with you today are not so simple; they are not easy to
read thermometers of the economy's health; and worse still, there may
be trade-offs, in which the economist's task is to describe
alternative consequences of different policies, but in which 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 became all the more important when
we come to broaden the objectives, in the final part of this talk.

Macroeconomic Stability

Controlling Inflation
Probably the most important element of the stabilization packages
promoted by the IMF and others has been controlling inflation. The
argument for aggressive, pre-emptive strikes against inflation is
based on three premises. The most fundamental premise is that
inflation is costly. This provides the motivation for trying to avert
or lower inflation. The second premise is that once inflations starts
to rise it has a tendency to accelerate out of control. This belief
provides a strong motivation for erring on the side of caution in
fighting inflation. Finally, the third premise is that increases in
inflations are very costly to reverse.  The implication of this
premise is that even if you care much more about unemployment than
inflation, you will still 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 are
hypotheses that can be tested empirically. I have discussed this
evidence in more detail elsewhere (Stiglitz, 1997). Here I would like
to summarize briefly. The evidence has only shown that high inflation
is costly. Bruno and Easterly (1996) found that when countries cross
the threshold of 40 percent per year inflation they fall into a
high/low growth trap. But below that level, their is no evidence that
inflation is costly.  Barro (1997) and Fischer (1993) also confirm
that high inflation is, on average, deleterious for growth, but again
have failed to find any evidence for costs of low levels of inflation.
Fischer also found the same results for the variability of inflation. 
 Recent research by Akelod, Dickens and Perry (1996) has suggested
that low levels of inflation may even improve economic performance.
The evidence o the accelerationist hypothesis (also known as letting
the genie out of the bottle or the slippery slope) is unambiguous:
there is no evidence that the increase in the inflation rate is
related to past increases in inflation. Finally, in reference to the
third proposition, some recent work has suggested that the Phillips
curve may be concave, and thus that the costs of reducing inflation
may be smaller than the benefits of incurred when inflation was
rising. In my view, the conclusion of this research into the
consequences of inflation is that controlling high and medium
inflation should be a fundamental policy priority, but that pushing
low inflation even lower is not likely to significantly improve the
functioning of the markets. In 1995, more than half of the countries
in the developing world had inflation rates below 15 percent (Chart
3). For these 71 countries, controlling inflation should not be one of
the major priorities. Controlling inflation is probably an important
component of stabilization and reform in the 22 countries, almost all
of them in Africa, Eastern Europe and the former Soviet Union, with
inflation rates above 40 percent. Interestingly, the Washington
Consensus' emphasis on inflation was, if anything, less relevant in
the 1980s when even fewer countries had very high inflation rates.

The budget deficit and current account deficit
A second component of macroeconomic stability has been reducing the
size of the 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. Like
inflation, much evidence shows that large budget deficits are
deleterious for economic performance (Fischer 1993 and Easterly et al
1994).  The three methods of financing deficits all drawbacks:
internal finance raises domestic interest rates, external financing
can be unsustainable, and money creation causes inflation. But there
is no simple optimum level of the budget deficit. The optimum
deficit-on the range of sustainable deficits - depends on
circumstances, including the cyclical state of the economy, prospects
for future growth, the uses of government spending, the depth of
financial markets, and the levels of national savings and national
investment. The United States, for example, is currently trying to
balance its budget. Personally, I think that the low savings rate and
the again of the baby boom suggest that the United States should
probably aim for budget surpluses. In contrast, the case for
maintaining budget surpluses in the East Asian countries, with their
high private savings and transitory growth slowdown, is less
compelling. The experience of a country I visited last year, Ethiopia,
emphasized another determinant of optimal deficits, the source of
financing. For the last several years Ethiopia has run a deficit of
about 8 percent of GDP. Some policy advisers would like Ethiopia to
lower its deficit. Others have argued that the deficit is financed by
a steady and predictable inflow of highly concessional foreign
assistance, aid driven not by the necessity of filling a budget gap
but by the availability of high returns to investment. In these
circumstances - and given the high returns to government investment in
such crucial areas as primary education and physical infrastructure
(especially roads and energy) - it may make sense for the government
to treat foreign aid as a legitimate source of revenue, just like
taxes, and balance the budget inclusive of foreign aid. The optimal
level of the current account deficit is also indeterminate in general.
Current account deficits, as we all know, occur when a country invests
more than it saves. They are neither inherently good nor inherently
bad, but depend on the circumstances, and especially on the use of
that investment. In many countries the rate of return on investment
far exceeds the cost of international capital. In these circumstances
current account deficits are sustainable. The form of the financing
also matter. The advantage of foreign direct investment is not just
the capital and knowledge that it supplies, but also the fact that it
tends to be very stable. In contrast, Thailand's 8 percent current
account deficit last year was not only large but came in the form of
short-term, dollar-denominated debt that was used to finance
local-currency denominated investment, often in excessive and
unproductive uses like real estate. More generally, short-term debt
and portfolio flows can bring the costs of high volatility without the
benefits of knowledge spillovers. 

Stabilizing output and promoting long-run growth
Ironically, macroeconomic stability - as seen by the Washington
Consensus - typically downplays the most fundamental sense of
stability: stabilizing output or unemployment. Minimizing or avoiding
major economic contractions should be one of the most important goals
of policy. In the short-run, large-scale involuntary unemployment is
clearly inefficient - in purely economic terms it represent idle
resources that could be used more productively. Also some research I
have contributed to has emphasized that the business cycles themselves
can have important consequences for long-run growth.  We argued that
the difficulty of borrowing to finance research and development means
that firms will need to drastically reduce their expenditures on
research and development when their cash flow decreases in downturns.
The result is slower total factor productivity growth in the future.
We have found evidence that this effect is important in the United
States; whether or not it matters in countries in which research and
development plays less of a role requires further research. But more
generally, variability of output almost certainly contributes to
uncertainty, and thus discourages investment. Variability of outputs
is especially pronounced in developing countries.  Chart 4 illustrates
this point. It shows that the median of the standard deviation of
annual growth rates by developing country region and income group. The
median high-income country has a standard deviation of 2.8. But for
developing countries the standard deviation is 5 percent or higher -
implying huge deviations in the growth rate. As one would expect,
growth is especially volatile in Europe and Central Asia, the Middle
East and North Africa, and sub-Saharan Africa. How can we promote
macroeconomic stability in the sense of stabilizing output or
employment? The traditional answer is good macroeconomic policy,
including countercyclical monetary policy and a fiscal policy that
allows automatic stabilizers to operate. These policies are certainly
necessary, but a growing literature, both theoretical and empirical,
has emphasized the important microeconomic underpinnings of
macroeconomic stability. This literature, to which I have contributed,
has emphasized the importance of financial markets and explains
economic downturns through such mechanisms as credit rationing and
banking and firm failures. In the nineteenth century most of the major
economic downturns in developed countries resulted from financial
panics that were sometimes preceded by but invariably led to
precipitous declines in asset prices and widespread banking failures.
In some countries, improvements in regulations and supervision, the
introduction of deposit insurance, and the shaping of incentives for
financial institutions, have all reduced the incidence and severity of
financial panics. Even so, financial crises continue, and there is
some evidence that they gotten more frequent and more severe in recent
years (Caprio and Kingebiel 1997). The losses from the notorious
Savings and Loan debacle in the United States wee, even after
adjusting for inflation, several times larger than the losses
experienced in the Great Depression. Yet this debacle, when measured
relative to GDP, would not make the top 25 banking crises since the
early 1980s. Chart 5 shows the fiscal cost of banking crises as a
fraction of GDP in selected countries. Banking crises have severe
macroeconomic consequences. Chart shows the effect of banking crises
on growth over the five following years. During the period 1975-94,
growth edged up slightly in countries that did not experience banking
crises. Countries with banking crises saw growth slow by 1,3
percentage points in the 5 years following a crisis. Clearly building
robust financial systems is a crucial part of promoting macroeconomic
stability.