By Joseph Stiglitz
Senior Vice President and Chief Economist, The World Bank
The 1998 WIDER Annual Lecture
January 7, 1998
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. 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.
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.
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.
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.
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.
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.
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.
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.
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 promotinghuman 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.
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.
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