stiglitz on neoliberalism 2/3

[Robert Weissman <rob@essential.org>]

Financial Reform
The importance of building robust financial systems goes beyond simply
averting economic crises. I have sometimes likened the financial
system to the "brain" of the economy. It plays an important role in
collecting and aggravating savings from agents who have excess
resources today. These resources are allocated to others - like
entrepreneurs and home builders - who can make productive use of those
resources. Well-functioning financial systems do a very good job of
selecting the most productive recipients for these resources. In
contrast, poorly-functioning financial systems will often allocate
capital to low-productivity investments. Selecting projects is only
the first stage. The financial system needs to continue to monitor the
use of funds, ensuring that they are continuing to be used
productively. In the process, they serve a number of other functions,
including reducing risk, increasing liquidity, and conveying
information. All of these functions are essential to both the growth
of capital and the increase in total factor productivity. Left to
themselves, financial systems will not do a very good job in
fulfilling these functions. These most important lesson of the theory
and observation of financial markets is the pervasiveness of market
failure. Incomplete information, incomplete markets, and incomplete
contracts are all particularly severe in the financial sector,
resulting in an equilibrium that is not even constrained Pareto
efficient (Greenwald and Stiglitz 1986). A sound legal framework
combined with regulation and oversight is necessary to mitigate these
informational problems and foster the conditions for efficient
financial markets. In successful financial markets, regulations serve
four purposes: maintaining safety and soundness (prudential
regulation), promoting competition, protecting consumers, and ensuring
that undeserved groups have some access to capital. In many cases, the
pursuit of social objectives - like ensuring a supply of funds to
minorities and poor communities, as under the United States' Community
Reinvestment Act - or ensuring a supply of funds for mortgages, the
essential mission of the government created Federal National Mortgage
Association - or ensuring a supply of funds for small businesses, the
central objective in the United States of the Small Business
Administration - can, if done well, reinforce economic objectives.
Similarly, protecting consumers is not only good fiscal policy, but
without confidence that there is a "level playing field" in economic
markets, those markets will remain thin and ineffective. There are
times, however, when policy makers might face tradeoffs among
conflicting objectives. For instance, the Est Asian countries adopted
financial restraints. These restraints increased the franchise values
of banks, discouraging them from taking unwarranted risks that
otherwise might have destabilized the banking sector. Although there
were undoubtedly some economic costs associated with these restraints,
the gains from greater stability almost surely outweighed these
losses. Previous efforts by the World Bank and others have tried to
build better banking systems. In practice, however, the changing
including institutional development, changes in credit culture, and
moral hazard have all proven more intractable and harder to make
progress on than short-term solutions like recapitalizing the banking
system. In the worst cases these temporary fixes may even have
undermined pressures for further reform. And since the fundamental
problems were not addressed, we would sometimes find ourselves
returning to the same countries over and over again. The Washington
Consensus developed in a context of highly regulated financial
systems, while many of the regulations were designed to limit
competition, not to promote of the four legitimate objectives of
regulation. But all too often the dogma of liberalization became an
end in itself not a means to a better financial system. I do not have
time to delve into all of the many facets of liberalization, which
include freeing up deposit and lending rates, opening up to foreign
banks, removing restrictions from capital account transactions, and
removing restrictions on bank lending. But I do want to make a few
general points. First, the key issue would not be liberalization or
deregulation, but the construction of the regulatory framework which
ensures an effective financial system. This will require, in many
countries, changing the regulatory framework, eliminating regulations
which serve only to restrict competition and prudential behavior (and
to ensure that banks have appropriate incentives). Second, even once
the design of the desired financial system is in place, due care will
have to be exercised in the transaction. The attempt to initiate
overnight deregulation, sometimes known as the "big bang", ignores the
very sensitive issues of sequencing. Thailand, for instance, used to
have restrictions on bank lending to real estate. In the process of
liberalization it got rid of these restrictions without establishing a
more sophisticated risk-based regulatory regime. The result, together
with other factors, was the large-scale misallocation of capital to
fuel a real estate bubble, an important factor in the financial
crisis. It is important to recognize how difficult it is to establish
a vibrant financial sector. Even economies with sophisticated
institutions, like the United States and Sweden, have faced serious
problems with their financial sectors. The challenges facing less
developed countries are all the greater, and yet the institutional
base from which they start is all the weaker. Third, in all countries,
a primary objective of regulation should be to ensure that
participants have the right incentives: government cannot and should
not be involved in monitoring every transaction. In the banking
system, liberalization will not work unless regulations create
incentives for bank owners, markets, and supervisors to all use their
information efficiently and act prudentially. It is equally important
to address incentive issues in securities markets. It must be more
profitable for managers to create economic value than to deprive
minority shareholders of their assets: rent seeking can be every bit
as much a problem in the private as in the public sector. The Czech
Republic has shown that without the appropriate legal framework,
securities markets can simply fail to perform their vital functions -
much to the detriment to the country's long-term economic growth. Laws
are required to protect the interests of shareholders, especially of
minority shareholders. The focus on the microeconomic, particularly
financial underpinnings of the macroeconomy also has implications for
responses to currency turmoil. In particular, where currency turmoil
is the consequence of a failing financial sector, the conventional
policy response to increase interest rates may be counterproductive. 
The maturity and interest rate composition of bank and corporate
assets and liabilities are frequently very different, in part because
of the strong incentives for banks to use short-term debt to monitor
and influence the firms they lend to and for depositors to use
short-term deposits to monitor and influence banks (Rey and Stiglitz
1993). As a result, interest rate increases can lead to substantial
reductions in bank net worth - further exacerbating the banking
crisis. Empirical studies by IMF and World Bank economists have
confirmed that interest rate rises tend to increase the probability of
banking crises and that currency devaluations have no significant
effect (Demirguc-Kunt and Detragiache 1997). There is another reason
that government should perhaps be more sensitive to interest rate
changes than exchange rate changes: while there is an economic logic
between maturity mismatches, there is no corresponding justification
for exchange rate mismatches. There is a real cost associated with
forcing firms to reduce the former. Exchange rate mismatches, by
contrast, simply represent speculative behavior. In practice, policy
cannot rely on these general nostrums, but needs to look carefully at
the situation within the country in crisis: it is possible that
currency mismatches are far larger than the maturity mismatches, and
while future actions might be directed at correcting such speculation
with its systemic effects, current policy must deal with the realities
of today.

Competition
I want to return back to our broader theme: making markets work
better. So far, I have argued that macroeconomic policy needs to be
broadened out beyond a single minded focus on inflation and budget
deficits: the set of policies which underlay the Washington Consensus
are neither necessary nor sufficient either for macro-stability or
long-term development. Macro-stability and long-term development
require sound financial markets; but the agenda for creating sound
financial markets should not confuse means with ends; financial
liberalization is not the issue - redesigning the regulatory system
should be. I now want to argue that central to the success of a market
economy is competition. Here too there was some confusion between
means and ends. Policies which should have been viewed as means to
achieve a more competitive market place were seen as ends in
themselves; and as a result, in some instances, they failed to attain
their objectives. The Fundamental Theorems of Welfare Economics, the
results that establish the efficiency of a market economy, have two
basic assumptions: private property and competitive markets. Many
countries - especially developing and transition economies - are
lacking in both. Until recently, however, emphasis has been placed
almost exclusively on creating private property and liberalizing trade
- with the latter being confused with establishing competitive
markets. I will argue that these are important - but that we are
unlikely to realize their full benefits without creating a competitive
economy.

Free Trade
Trade liberalization, leading eventually to free trade, was a key part
of the Washington Consensus. The emphasis on trade liberalization was
natural: the Latin American countries had stagnated behind
protectionist barriers.  Import substitution proved a highly
ineffective strategy for development. In many countries, industries
were producing products with negative value added and innovation was
stifled.  Trade liberalization may create competition, but it does not
do so automatically. It trade liberalization occurs in an economy with
a monopoly importer then rents may just be transferred from the
government to the monopolist, with little decrease in price. Trade
liberalization is neither necessary nor sufficient for creating a
competitive and innovative economy. As or more important than creating
competition in the previously sheltered import-competing sector of the
economy is promoting competition on the export side. The success of
East Asian economies is a particularly powerful example of this point.
By allowing each country to take advantage of its comparative
advantage, trade increases wages and expands consumption
opportunities. For the last 15 years, trade has been doing just that -
with world trade growing at a 5 percent annual rate, nearly twice the
rate of world GDP growth. Interestingly, we do not fully understand
the process by which trade liberalization leads to enhanced
productivity. The standard Hecksher-Ohlin theory predicts that
countries will shift intersectorally, moving along their production
possibility frontier. They will produce more of what they are better
at and trade for what they are worse at. In reality, the main gains
from trade seem to come intertemporally, from an outward shift in the
production possibility frontier from increased efficiency, with little
sectoral shift. Understanding the causes of this improvement in
efficiency, requires us to understand the links between trade,
competition and liberalization. This is an arena that needs to be
pursued further. 

Privatization
In many countries, there exist (or existed) state monopolies in
certain industries. These stifled competition. But the emphasis on
privatization over the past decade has come not so much from the
concern about competition, as from a focus on incentives. As I said
earlier, essential to a market economy are free, competitive markets
and private property. Many countries - especially those in the former
socialist bloc - lacked both. The Washington Consensus focused more on
privatization than on competition. In a sense, it was natural for them
to do so. Not only were the state enterprises inefficient, but their
losses contributed to the government's budget deficit, contributing to
macro-instability. Privatization would kill two birds with one stone:
it would simultaneously improve economic efficiency and reduce fiscal
deficits. The idea as that if one could create property rights, then
the profit-maximizing behavior of the owners will eliminate waste and
inefficiency. At the same time, the sale of the enterprises would
raise much needed revenue. In the transition economies the rapid
privatization represented a reasonable gamble. Although most people
would have preferred a more orderly restructuring and establishing an
effective legal structure (covering contracts, bankruptcy, corporate
governance, and competition), no one knew how long the reform window
would stay open. At the time, privatizing quickly and comprehensively
- and then fixing the problems later on - seemed a reasonable gamble.
In retrospect, the advocates of privatization overestimated the
benefits of privatization and underestimated the costs, particularly
the political costs of the process itself and the impediments to
further reform. Taking the same gamble today, with the benefit of 7
more years of experience, would be much less justified. Even at the
time many of us warned against hastily privatizing without creating
the needed institutional infrastructure - including competitive
markets and regulatory bodies. David Sappington and I showed in the
Fundamental Theorem on Privatization, the conditions under which
privatization can achieve the public objectives of efficiency and
equity are very limited, and are very similar to the conditions under
which competitive markets attain Pareto-efficient outcomes (Sappington
and Stiglitz 1987). If, for instance, competition is lacking then
creating a private, unregulated monopoly will likely result in even
higher prices for consumers. And there is some evidence that,
insulated from competition, private monopolies may suffer from several
forms of inefficiency and may not be highly innovative. Indeed, both
large-scale public and private enterprises share many similarities and
face many of the same organizational challenges. Both models involve
substantial delegation of responsibility - neither legislatures nor
shareholders in large companies directly control the daily activities
of an enterprise. In both cases, the hierarchy of authority terminates
in managers who typically have a great deal of autonomy and
discretion. Rent seeking occurs in private enterprises, just as it
does in public enterprises. For instance, Shleifer and Vishny (1989)
and Edlin and Stiglitz (1995) have shown that there are strong
incentives not only for private rent seeking on the part of
management, but for taking actions which increase the scope for such
rent seeking. In the Czech Republic, the bold experiment with voucher
privatization seems to have foundered on precisely these issues. The
issue may not be that public organizations cannot provide just as
effective incentives, but that typically they do not, and they impose
a variety of additional constraints.
 Not only are the differences between public and private enterprises
 blurry, but there is also a continuum of arrangements in between.
 Corporatization, for instance, maintains government ownership but
 shifts towards hard budget constraints and self-financing. (Another
 alternative is performance-based government organizations, which use
 output-oriented performance measures.) Some evidence suggests that
 much of the gains from privatization occur prior to privatization -
 they arise from the process of corporatization, from putting place
 effective individual and organizational incentives (Caves and
 Christensen 1980 and Pannier 1996).
The importance of competition rather than ownership has been most
vividly demonstrated by the experience of China and Russia. China has
managed to sustain double-digit growth by extending the scope of
competition, without privatizing state-owned enterprises. To be sure,
they face a number of problems in the state-owned sector that are
hopefully being addressed in the next stage of their reforms. In
contrast, Russia has privatized a large fraction of its economy
without doing much so far to promote competition. The consequence of
this and other factors has been a major economic collapse. The
magnitude and duration of this collapse is itself somewhat of a
puzzle, at least for standard economic theory. The Soviet economy was
widely considered rife with inefficiencies and a substantial fraction
of its output was devoted to military expenditures. The elimination of
these inefficiencies should have raised GDP  and the reduction in
military expenditures should have increased personal consumption still
further. Yet neither seems to have occurred. The magnitude and success
of China's economy over the past two decades also represents a puzzle
for standard theory. The economy not only eschewed a strategy of
outright privatization, but also failed to incorporate numerous other
elements of the liberalization/Washington Consensus doctrine. Yet
China represents the greatest success story of the last two decades.
This can be seen in a number of different ways. If China's 30
provinces were treated as separate economies, and many of them have
populations exceeding those of most other low-income countries, then
the 20 fastest-growing economies between 1978 and 1995 would all have
been Chinese provinces (World Bank 1997a). Alternatively, almost
two-thirds of aggregate growth in low-income countries between 1978
and 1995 is accounted for by the increase in China's GDP (while its
GDP in 1978 only represented roughly one-quarter of the aggregate GDP
of low-income countries and its population represented only 40 percent
of the total). One of the important lessons of the contrast between
China and Russia is for the political economy of privatization and
competition. Privatizing monopolies creates huge rents. It has proved
difficult to administer privatization without encouraging corruption
and other problems. Entrepreneurs will have the incentive to try to
secure privatized enterprises rather than invest in crating their own
firms. In contrast, competition policy often undermines rents and
creates incentives for wealth creation. Furthermore, the sequencing of
privatization and regulation is very important. Privatizing a monopoly
can create a powerful entrenched interest that undermines the
possibility of regulation or competition in the future. The Washington
Consensus is right - privatization is important. The government needs
to devote its scarce resources to areas that the private sector does
not and is not likely to enter. It makes no sense for the government
to be running steel mills. Government needs to focus its attention on
those areas that represent its distinct advantages, which distinguish
it from private organizations.  But that having been said, there are
critical issues both about the sequencing and scope privatization:
Even when privatization increases productive efficiency, there may be
problems in ensuring that broader public objectives, not well
reflected in market prices, are attained, and regulation may be an
imperfect substitute. Should prisons, social services, or the making
of atomic bombs (or the central ingredient of atomic bombs, highly
enriched uranium) be privatized, as some in the United States have
advocated? Where are the boundaries? One can introduce more private
sector activity into public activities, e.g. through contracting and
more incentive-based mechanisms like auctions. How effective of a
substitute are these to outright privatization? These are issues which
all too often the Washington Consensus suppressed under the mantra of
privatization. Moreover, as we have seen, sequencing matters, not only
because many of the benefits of privatization are achieved only in the
context of competitive markets, but also because powerful interest
groups can be created which suppress competition or which resist
regulations to curb the abuses of monopoly power. Regulation As I have
noted, competition is an essential ingredient of a successful market
economy. But there are some sectors of the economy in which
competition is not viable - the so-called natural monopolies. The
extent and form of competition, however, are constantly changing. New
technologies have expanded the scope for competition in many sectors
that have historically been highly regulated, such as
telecommunications and electric power. Traditional regulatory
structures, however, with their rigid categories of regulation versus
deregulation and competition versus monopoly, have been increasingly
unhelpful guides to policy in these areas. These new technologies do
not call for wholesale deregulation because not all parts of these
industries are adequately competitive. Instead they call for
appropriate changes in regulatory structure to meet the new
challenges. Such changes must recognize the existence of hybrid areas
of the economy, some parts of which are more suited to competition,
while others are more vulnerable to domination by a few. Market power
in one part of a regulated industry cannot be allowed to maneuver
itself into a stranglehold over other parts, or else economic
efficiency may be severely compromised.

Competition Policy
Although the scope of viable competition has expanded, for a variety
of reasons competition is often far less perfect, especially in
developing countries. We have come to understand the variety of ways
by which competition is suppressed - from implicit collusion to
predatory pricing. We know that control of the distribution system may
effectively limit competition even when there are many producers. We
have become aware of the potential for vertical restraints in
restricting competition. And just as new technologies have opened up
new possibilities for competition, so too have they opened up new
opportunities for anti-competitive behavior, as recent cases in the
U.S. airline and computer industry have evidenced. The development of
effective antitrust laws for developing countries remains an
understudies area. Surely, the sophisticated and complicated legal
structures and institutions that characterize antitrust in the United
States may not be appropriate for many developing countries. There may
have to be greater reliance on per se rules. Competition policy also
has important implications for thinking about trade policy. Currently,
most countries have separate rules governing domestic competition and
international competition (Australia and New Zealand are exceptions).
With little if any justification, the rules governing competition in
international trade (e.g. anti-dumping provisions and countervailing
duties) are substantially stricter than domestic antitrust laws. 
Under these laws, much of what we see domestically as healthy price
competition would be classified as dumping. These abuses of fair trade
were pioneered in the advanced countries, but are now spreading to the
developing countries - which surpassed industrial countries in the
initiation of antidumping actions reported to the GATT/WTO for the
first time in 1996 (World Bank 1997b). The best way to curtail these
abuses would be the full integration of fair trade and fair
competition laws, based on the deep understanding of the nature of
competition that antitrust authorities and industrial organization
economists have evolved over the course of a century.