stiglitz on neoliberalism 3/3

[Robert Weissman <rob@essential.org>]

Government as a Complement to Markets
So far I have been discussing the ways in which the Washington
Consensus on the issues of macroeconomic stabilization, financial
reform, liberalized trade, and privatization, was insufficient. It
contained important elements but in many ways does not go far enough
in promoting issues like financial sector reform and competition
policy. The next issues I am going to discuss are vital questions that
the Washington Consensus did not even address ( or underemphasized).
The first set of issues concern what the government should do and the
second how it can what it does more effectively. For much of this
century people have looked to government to do more - spend more and
intervene more. Government spending as a share of GDP has grown with
these demands. The Washington Consensus policies I have discussed were
based on a rejection of the state's activist role and the promotion of
a minimalist, non-interventionist state. The unspoken premise is that
governments are presumed to be worse than markets. Therefore the
smaller the state the better (i.e. less bad) the state. As should be
clear from my remarks, I do not believe in blanket statements like
"government is worse than markets".  I have argued that government has
an important role in responding market failures, which are a general
feature of any economy with imperfect information and incomplete
markets. The implication of this view is that the task of making the
sate more effective is considerably more complex than just shrinking
its size. Typically the state is involved in too many things, in an
unfocused manner and as a result is less effective than it might be.
The success of an organization depends on focus. Trying to get
government better focused on the fundamentals - economic policies,
basic education, health, roads, law and order, environmental
protection - is a vital step. But focusing on the fundamentals is not
a recipe for minimalist government. The state has an important role to
play in appropriate regulation, industrial policy, social protection
and welfare. The choice should not be whether the state should or
should not be involved. Instead, it is often a matter of how it gets
involved. More importantly, we should not see the state and market as
substitutes. I would like to argue that the government should see
itself as a complement to markets, undertaking those actions that make
markets fulfill their functions better - as well as correcting market
failures. We have already discussed one important instance, in the
financial sector, where, without appropriate government regulations,
the sector simply does not function well (see also Stiglitz 1993).
Countries with successful economies also have governments that are
involved in a range of other activities. In some cases, an argument
can be made that the government has proven to be an effective catalyst
- its actions help solve the problem of undersupply of (social)
innovation. But once it has performed its catalyst role, it needs to
withdraw. Thus, in the United States, the government established a
national mortgage system, which has lowered borrowing costs and made
available mortgages to millions of Americans - leading to one of the
highest home ownership rates in the world. But having done this, it
may be time for this activity to be turned over to the private sector.
In the limited amount of time available today, I cannot review all, or
even the most important areas in which government can serve as an
important complement to markets. I shall discuss briefly only two, one
in which there is little disagreement about the paramount role of
government, but in the other of which attracts less attention.

Human capital
The role of human capital in economic growth has long bee appreciated.
Studies have found that the returns to an additional year of education
in the United States, for instance, are between 5 and 15 percent. 
Growth accounting also attributes a substantial portion of growth in
developing countries to human capital accumulation. The East Asian
economies, for instance, emphasized the role of government in
providing universal education, which was a necessary part of their
transformation from agrarian to rapidly industrializing economies.
Left to itself, the market will tend to under provide human capital.
It is very difficult to borrow against the prospects of future
earnings since human capital itself is not collaterizable. These
difficulties are especially severe for less wealthy families. The
government plays an important role in providing public education,
using other methods to make education more affordable and enhancing
access to funding.

The transfer of technology
Studies of the returns to research and development in industrial
countries have consistently found individual returns in the range of
20 to 30 percent and social returns of 50 percent or even higher - far
exceeding the returns to education (Nadiri 1993). Growth accounting
usually attributes the majority of per capita income growth to
improvements in total factor productivity - Solows's (1957) pioneering
analysis attributed 87.5 percent of the increase in output per man
hour between 1909 and 1949 to technical change.  Based on a standard
Cobb-Douglas production function, Korea's per capita income in 1990
would only have been $2,041 (in 1985 international dollars) if it had
relied solely on capital accumulation. In reality, its per capita
income was $6,665, three times higher. The difference comes from
increasing the amount of output per unit of input, which partly is the
result of improvements in technology. The case that, by itself, the
market under provides technology is even more compelling than the case
for education. Investments in technology are subject to the similar
financing problems as education because the investment cannot be used
as collateral. Investments in R&D are also considerably more risky and
open up much more serious adverse selection problems. More
importantly, technology has enormous externalities. Knowledge is like
a public good - you cannot exclude others from enjoying the benefits
(non-excludability) and my consumption does not diminish your ability
to consume it (non-rivalrous). As one of the America's great
Presidents, Thomas Jefferson, once said: ideas are like a candle, you
can use them to light other candles without diminishing the original
flame. As such, the benefits to society of increased investment in
technology far outweigh the benefits to individual entrepreneurs.
Without government action there will be too little investment in the
production and adoption of new technology. For most countries not at
the technological frontier, facilitating the transfer of technology
has much higher returns than original research and development.
Policies to facilitate the transfer of technology are thus one of the
keys to development. One aspect of these policies is investing in
human capital, especially in tertiary education. The argument for
funding universities is not just the provision of human capital to
particular individuals, but the major externalities that come from
enabling the economy to import ideas. Of course, many developing
countries have high unemployment rates for university graduates, and
have many more university graduates employed by unproductive civil
service jobs. These countries have probably overemphasized liberal
arts educations. In contrast, Korea has narrowed the productivity gap
with the lead countries through the training of scientists and
engineers. Another policy that can promote the transfer of technology
is foreign direct investment. Singapore, for example, was able to
assimilate rapidly the knowledge that came from its large inflows of
foreign direct investment. Finally, I would like to note briefly that
policies adopted by the technological leaders matter also. There can
be a tension between the incentives to produce knowledge and the
benefits from more effective dissemination. In recent years many -
including small firms in developed countries, the academic community
throughout the world, and many in developing countries - have become
concerned that the balance developed countries have struck, often
under pressure from special interest groups, underemphasizes
dissemination. The consequences, they argue, may slow both the overall
pace of innovation and adversely affect living standards in both
richer and poorer countries. 

Making Government More Effective
Let me return for a moment to our objective of this part of the talk:
how do we design policies that increase the productivity of the
economy? I have stressed that we should not confuse ends with means;
that the elements stressed by the Washington Consensus may have been
reasonable means for addressing the particular set of problems
confronting, say, the Latin American economies in the 1980s, but they
may not be the only, or even the central, elements of policies aimed
at addressing the problems in other circumstances. Part of the
strategy for a more productive economy that I have just stressed is
ascertaining the appropriate role for government: identifying, for
instance, the ways in which government can be a more effective
complement to markets. I now want to turn to another essential element
of public policy: how we can make government more effective in
accomplishing whatever tasks it undertakes. This year's World
Development Report shows that an effective state is vital for
development (World Bank 1997c). Using date from 94 countries over
three decades, we show in our Report that it is not just economic
policies and human capital, but the quality of a country's
institutions that determine economic outcomes. They, in effect, set
the overall environment under which the markets operate. A weak
institutional environment allows greater arbitrariness on the part of
state agencies and public officials. Given very different starting
points, very unique history, culture and societal factors, how does on
make the state more effective? Part of the answer is that the state
should match its role to its capability. What the government does, and
how it does it, should obviously reflect the capabilities of the
government - and those of the private sector. Low-income countries
often have weaker markets and weaker government institutions. It is
especially important therefore that they focus on how they can most
effectively complement markets. But capability is not destiny. States
can improve their capabilities by reinvigorating their institutions.
This does not mean merely building administrative or technical
capacity. But more importantly, it means instituting rules and norms
that provide state officials with incentives to act in the collective
interest while restraining arbitrary action and corruption. Five
interrelated mechanisms can help to enhance state capability:

· First, rules and restraints are crucial for a professional and
capable bureaucracy. An independent judiciary, institutional checks
and balances through the separation of powers, and effective watchdogs
can all restrain arbitrary state action and corruption. · Second, the
civil service itself needs to be more effective, offering competitive
wages to attract talented people. · Third, state capability can also
be enhanced through voice and partnerships by bringing the government
close to the people and by seeking stakeholder feedback in policy
making and service delivery. · Fourth, there are ways in which
governments can improve their efficiency and efficacy by using
market-like mechanisms in the public sector. For instance, designing
and using performance standards, establishing incentive systems based
on performance standards, employing auctions for procurement and
selling public assets, such as spectrum licenses, and using
performance standards for regulations in areas like environment and
safety. · Finally, the state needs to adopt policies that reduce the
scope for rent seeking. Market mechanisms, like auctioning of natural
resources or spectrum allocations, is one way to reduce the private
sector's incentive to push for artificial creation of scarcity. In
addition, curtailing discretionary activities - like licensing and
trade restrictions - also reduces rent seeking.

BROADENED GOALS OF DEVELOPMENT

The Washington Consensus advocated a set of instruments (including
macroeconomic stability, liberalized trade, and privatization) to
achieve a relatively focused goal (economic growth). The
post-Washington Consensus begins by recognizing that a broader set of
instruments are necessary to achieve those goals. I have discussed
some of the most important instruments, including financial
regulation, competition policy, investments in human capital, and
policies to facilitate the transfer of technology. The second theme of
my remarks is that the post-Washington Consensus also recognizes that
our goals are much broader. We seek increases in living standards -
including improved health and education - not just increases in
measured GDP. We seek sustainable development, which includes
preserving our natural resources and maintaining a healthy
environment. We seek equitable development, which ensures that all
groups in society enjoy the fruits of development, not just the few at
the top. And, we seek democratic development, in which citizens
participate in a variety of ways in making the decisions which affect
their lives. Knowledge has not kept pace with the proliferation of our
goals. We are only beginning to understand the relationship between
democratization, inequality, environmental protection, and growth.
What we do know holds out the promise of developing complementary
strategies that can move us toward all of these objectives. But we
must recognize that given our highly multi-dimensional objective space
not all policies will contribute to all objectives. There will be
tradeoffs and hard choices. We need to improve our understanding of
these inevitable tradeoffs if we are going to be able to make more
informed choices in the future. I would like to illustrate this by
discussing four policy areas, two in which policies can achieve
complementary goals and two of which inevitably entail tradeoffs.

Complement 1: Education
Promoting human capital is one example of a complementary policy, one
that can help promote economic development, equality, participation,
and democracy. Again the East Asian experience contains important
lessons. I have already discussed the role of education in promoting
human capital and growth. In East Asia, universal education also
created a more egalitarian society, facilitating the political
stability that is a precondition for successful long-term economic
development. Furthermore education - especially an education which
emphasizes critical, scientific thinking - can help train citizens to
participate more effectively and more intelligently in public
decisions.

Complement 2: Environment
A second set of ways in which a single instrument can help achieve
multiple goals comes from environmental policy. I am going to focus
specifically on joint implementation of carbon reduction. In order to
minimize global climate change, the world needs to devise strategies
to reduce the production of greenhouse gasses, especially carbon
dioxide which is produced primarily by combustion. The reduction of
carbon emissions is truly a global problem. Unlike air pollution
(associated with SO2 or Nox), which primarily effect the polluting
country, all carbon emissions enter the atmosphere, producing global
consequences that are independent of their geographical origin. Joint
implementation gives developed countries (or companies within them)
credit for emissions reductions, that they would not otherwise have
undertaken, anywhere in the world. It may be a feasible first step
towards designing an efficient system of emission reductions because
it only requires commitments from developed countries, and therefore
does not entail resolving the huge distributional issues involved
either in systems of tradable permits or the undertaking of
obligations by developing countries. The premise of joint
implementation is that the marginal cost of carbon reductions may
differ markedly in different countries. In particular, developing
countries are typically less energy efficient than developed
countries. As a result, the marginal cost of carbon reduction in
developing countries may be substantially lower than in developed
countries. The World Bank has offered to set up a carbon investment
fund that would allow countries and companies that needed to pursue
emissions reductions to invest in carbon-reducing projects in
developing countries. For developed countries, this plan would offer
increased investment flows and pro-environment technology transfers.
These projects would also be likely to reduce the collateral
environmental damage caused by dirty air. And for developed countries,
joint implementation allows them to reduce carbon emissions at a lower
cost. This is a strategy which is designed to benefit the developing
countries as it improves the global environment.

Tradeoff 1: Investments in Technology
Not all policies are like investing in primary education or jointly
implementing emissions reduction. Many policies entail trade-offs. It
is important to face these tradeoffs and make choices about
priorities. Concentrating solely on "win-win" policies can lead policy
makers to ignore important decisions about "win-lose" policies. One
important example of a potential tradeoff I am going to discuss is
investments in technology. Earlier I discussed the way investments in
tertiary technical education promote the transfer of technology and
thus economic growth. The direct beneficiaries of these investments,
however, are almost inevitably better off than average. The result is
likely to be rising inequality. More generally, the transfer of
technology may even increase inequality. Although some innovations
benefit the worst off, much technological progress raises the marginal
products of those who are already more productive.. Even when it does
not, the opportunity cost of public investment in technology might be
foregone investment in anti-poverty programs. By increasing output,
however, these investments can benefit the entire society. The
potential trickle down, however Is not necessarily rapid or
comprehensive.

Tradeoff 2: Environment and Participation
The second example of a tradeoff I would like to discuss is between
environmental goals and participation. We now recognize that
participation is essential. But while participation is essential, we
should not be confused: participation is not a substitute for
expertise. Studies have shown, for instance, that popular views on the
ranking of various environmental health risks are uncorrelated with
the scientific evidence (Environmental Protection Agency 1987 and
Slovic et al 1993). In pursuing environmental policies, do we seek to
make people feel better about their environment, or do we seek to
reduce real environmental hazards? There is a delicate balance here,
but at the very least, more dissemination of knowledge can result in
more effective participation in formulating more effective policies.

CONCLUDING REMARKS

I would now like to make some concluding remarks. The goal of the
Washington Consensus was to provide a formula for creating a vibrant
private sector and stimulating economic growth. In retrospect the
policy recommendations were highly risk averse - they were based on
the desire to avoid the worst disasters. Although the Washington
Consensus provided some of the foundations for well-functioning
markets, it was incomplete and sometimes even misleading. The World
Bank's East Asian miracle project was a significant turning point in
the discussion. It showed that the stunning success of the East Asian
economies depended on much more than just macroeconomic stability or
privatization. I have explicitly discussed the "Lessons of the East
Asian Miracle" elsewhere (Stiglitz 1996), but the general ideas have
pervaded all of my remarks today. Without a robust financial system -
which the government plays a huge role in creating and maintaining -
it will be difficult to mobilize savings or to allocate capital
efficiently. Unless the economy is competitive, the benefits of free
trade and privatization will be dissipated in rent seeking, not
directed toward wealth creation. And if public investments in human
capital and technology transfers is insufficient, the market will not
fill the gap. Many of these ideas, and more still that I have not had
time to discuss, are the basis of what I see as an emerging consensus,
a post-Washington Consensus. One principle of these emerging ideas is
that whatever the new consensus is, it cannot be based on Washington.
In order for policies to be sustainable, they must receive ownership
by developing countries. It is relatively easier to monitor and set
conditions for inflations rates and current account balances. Doing
the same for financial sector regulation or competition policy is
neither feasible or desirable. The second principle of the emerging
consensus is a greater degree of humility, the frank acknowledgment
that we do not have all of the answers. Continued research and
discussion not just between the World Bank and the International
Monetary Fund, but throughout the world is essential if we are to
better understand how to achieve our many goals.

ENDS