Failure of economic reforms due to fundamental flaws in design

Neoliberal reforms in Latin America have led to inequality, poverty and little or no growth in much of the region because they have been based on a fundamentally flawed concept of what makes a market economy work, a noted economist says. Thus, observes Nobel laureate Joseph Stiglitz, “a reform strategy which promised to bring unprecedented prosperity has failed in an almost unprecedented way.”

by Chakravarthi Raghavan

GENEVA: The neoliberal reform agenda, and the “first generation” of reforms in Latin America, have failed, and the failure is due to the fundamental flaws in the reform agenda, according to Nobel economics laureate and Columbia University academic Professor Joseph Stiglitz.

Stiglitz blamed in particular the Washington Consensus policies of deregulation, privatization and liberalization of trade and capital flows promoted and pushed by the International Monetary Fund and its economists while often ignoring the roles of the market and the government, even under US-style capitalism.

Calling for a new agenda for reform, Stiglitz stressed that there was no single alternative nor should there be any attempt to promote a single agenda. Each country, he said, must choose the alternative appropriate for its conditions and its people, though some general principles and broad elements of an alternative agenda could be outlined. These principles and elements, Stiglitz said, would include social mobilization, ensuring equity, and creating a good business environment that not only attracts foreign investors but also provides a hospitable environment for domestic investors.

The US academic and mainstream economist, who quit as senior Vice-President at the World Bank after some serious policy differences and public controversies with the IMF and the US Treasury in the wake of the East Asian financial crisis, was delivering the second Prebisch lecture on 26 August at the Santiago-based UN Economic Commission for Latin America and the Caribbean (ECLAC).

Basic failings

In setting out the contours of the failure of the economic reforms, Stiglitz said that after a brief spurt in the early 1990s, growth in Latin America has slowed, and many countries are facing recession, depression and crisis - a few of an almost unprecedented level reminiscent of the Great Depression. Argentina, an A+ student for the first three quarters of the decade, is now vilified beyond measure. Brazil, too, a first-rate student of reform, is facing a crisis. “A reform strategy which promised to bring unprecedented prosperity has failed, in an almost unprecedented way.” Its critics said it might bring growth but were worried that the growth would not be widely shared. “The outcomes have been worse than many of its critics feared: it has not brought growth to much of the region, but, at least in some parts of the region, it has brought increased inequality and poverty.”

While there had been talk of a “second generation” of reforms to finetune the economies after they have digested the first generation, the fact is the reforms have failed because the first generation was “fundamentally flawed”, Stiglitz said. That it was not complete was clear. “But its failings were more basic.... It was based on a flawed concept of what makes a market economy work, and an appropriate analysis of the role of government.”

While the search for an alternative does not mean a return to the past, there is of course “no single alternative: each country must choose the alternative that is appropriate for its conditions and its people ... the attempt to promote a single agenda, untailored to the circumstances of each country, has been one of the main criticisms ... levelled against the Washington Consensus. But there are some overarching perspectives, some common themes, that are likely to be played out in many of the countries (in terms of alternatives),” said Stiglitz.

While Raul Prebisch (in his work at ECLAC) was concerned with the plight of Latin America, for example, worries about declining commodity prices, to the problems he was concerned with, several more have to be added, Stiglitz said.

The dimensions of the failure of the economic reforms are hard to fathom, he went on. Growth in the 1990s has been slightly greater than half of what it was in the 50s, 60s and 70s. “For a set of reforms that began by criticizing the failed policies of the past, this is hardly an achievement to boast of,” he said. Even if one took into consideration the argument that reforms take time to take effect, the news is even worse. Growth occurred in the first half of the decade, while in the second half there has been stagnation, recession and depression.

While the strong growth of the 50s, 60s and 70s was not sustained, it was not internal forces that brought it to an end, but shocks from outside - “the sudden and unexpected increase in interest rates in the US” that had made the Latin debt unsustainable.

That the increase in interest rates should have had such an impact was itself “as much a failing of international capital markets and the global financial regime as it was of Latin America.” One would have expected the sophisticated bankers of the advanced industrial countries to have done a risk analysis, showing if interest rates increase the debt would be unsustainable; or one would have expected the US Federal Reserve to have taken into account the full ramifications of raising interest rates to almost unprecedented levels. But none of these happened. The Fed was focussed on inflation, paying scant attention to what would happen to America’s own financial system. As a result, it effectively bankrupted the Savings and Loans Associations - and it took almost a decade for the US taxpayers to pick up the multi-billion-dollar tab - let alone what it would do to debtors abroad.

The economic leaders of the advanced industrial countries did not want to take full responsibility for these failures; “it was easier, politically far more plausible, to focus on failings within Latin America, and they were an easy prey.”

Challenging the view that, weak as it had been, growth in the 1990s was better than in the 1980s, Stiglitz said that it was the debt overhang that squashed the economies of the region in the 1980s, and the “lost decade” had more to do with the resolution of the problem of debt overhang than with reform strategies. The stagnation in the region had begun with the overbearing weight of debt. And even in terms of a period of catchup after stagnation before resumption of growth, though robust industrial growth did occur in the first half of the 90s, if the growth of the 80s and 90s were viewed as a whole, growth under reforms “was even more dismal, and barely positive.”

The argument that growth would have been sustained if only there had been no global financial crisis, missed the point in two respects. “To a large extent the global financial crisis was itself a product of the global reform movement, including capital market liberalization.”

The single factor that changed in East Asia - which till then had not only most rapid growth but also most stability, with two of the crisis countries having had only a single year of downturn and two having had not even one, a better performance than by the OECD - was not “growth of corruption and lack of transparency, as the IMF might have one believe.” In fact, in at least several of the affected countries corruption was being curtailed and transparency was increasing.

“Rather the problem was premature and excessively rapid financial and capital market liberalization, the failure to put into place adequate regulatory framework. Rather than asking what was the right regulatory framework, there was a single-minded focus on deregulation, with disastrous consequences. The fact is capitalism has always been marked by huge fluctuations and, if anything, these fluctuations have become even more marked in the developing world. The contrast between what has been happening in the developing world and what has happened in the developed should draw our attention.”

Even the most ardent advocates of American capitalism have said “markets exhibit excessive and irrational pessimism.” Strong economies like the US can withstand these vicissitudes, “but such volatility puts enormous strains on small, open, poor markets in an unprecedented way, both through trade (for instance, replacing quotas with tariffs, whatever its virtues in transparency, can expose a country to greater volatility) and through capital flows - and before they have strengthened their safety nets.”

Worse still, the reforms have replaced automatic stabilizers with automatic destabilizers. For Latin America as a whole, fiscal policy, rather than being counter-cyclical, has been pro-cyclical. And this is not because economists in Latin America have failed to read macroeconomic textbooks of the last 70 years in which the importance of counter-cyclical fiscal policy has been stressed. “Rather it is partly because the IMF, on which so many of the Latin American countries have become dependent for advice and money, has encouraged, and in some cases insisted, on these pro-cyclical policies.”

Reforms have meant opening these economies to capital flows, which are themselves pro-cyclical.

While the automatic fiscal stabilizers associated with fiscal policy have been replaced by an automatic destabilizer, monetary policy too has become a source of instability, and this is only likely to get worse in the future. The IMF has encouraged countries to rely more extensively on capital adequacy requirements and not to give in to forbearance.

“In East Asia we saw dramatically the consequences of this policy stance: as an economy goes into a downturn, defaults rise, banks’ balance-sheets worsen, and they are forced quickly, as a result, to contract lending.” The alternative of a fresh injection of capital is not feasible in the midst of an economic downturn, or the cost to current owners is sufficiently large that they find the course of action unattractive. As they contract lending, the downturn is exacerbated; “in some cases, even the balance-sheets of the banks do not improve or improve much, or they may even worsen.”

Perpetuating poverty

The World Bank’s decennial report on poverty has identified key dimensions of poverty as embracing not only lack of income but also insecurity and voicelessness. “The so-called reform strategies have exacerbated this problem. The increased macroeconomic instability is borne disproportionately by the poor. It is the unskilled labour that are thrown into unemployment and have no savings to turn to. And even the effect of a temporary downturn can be long-lasting, as those thrown out of work can’t afford to send their children to school. Once the education is interrupted, there is a high probability that they will not return, even when things improve.”

Even in countries that have experienced growth, such as Mexico, a disproportionate part of the benefits have gone to the upper 10%, with many of the poorest at the bottom 30% worse off. This is partly because those at the bottom bear the cost of economic fluctuations which are an inherent part of the market-oriented reform strategy.

“But it is also partly the consequence of the trade liberalization strategy,” Stiglitz charged. Markets were opened up, and jobs destroyed, in the naive belief that Say’s Law (supply creates demand) still held. When, not surprisingly, this did not happen, countries were blamed again for “excessive labour market rigidity.” Wages should fall even more, impoverishing the poor even more and, at low enough wages, firms would find it profitable to hire workers, it was argued.

“This ignored both theory and evidence. One of the major advances in economic theory of the last 30 years has been the efficiency wage theory - that lower wages may lower productivity, so much so that demand for labour increases very little, and possibly even decreases. Empirical work in the US has shown that the minimum wage has had little if any adverse impact on employment.”

In most of the countries in the region, the informal sector, in which conventional rigidities play no role, is huge. If the IMF economists were correct, then this sector by itself would be able to absorb all the labour. The rigid wage sector would shrink, there would be wage differentials and some inefficiency due to wage differentials, but the economy would still be at full employment. “The evidence is overwhelming against this hypothesis,” Stiglitz pointed out. “In Argentina, as the informal sector grew to embrace perhaps 50% of the economy, unemployment continued to grow - and it has been at double-digit rates since 1995.”

It is not wage rigidities so much as the IMF policies that are to blame: those policies have often undermined the ability of the economy to create new jobs, among others by forcing high interest rates. As a result, trade liberalization has resulted in workers moving not from low-productivity jobs to high-productivity jobs, but from low-productivity jobs to unemployment, Stiglitz commented.

“Matters have been made even worse, of course, as a result of the unfair trade regime. How could poor farmers in Chiapas compete with the heavily subsidized corn from the US? As corn prices fell with trade liberalization, so did the incomes of the poor farmers in Mexico. Mexico’s industrial workers in the north were better off, as the demand for exports to North America increased, but those at the bottom of income distribution were those who paid the price.”

Tyranny of markets

Referring to the third dimension of poverty, voicelessness, and the great achievement of Latin American reform, namely the restoration of democracy, Stiglitz said: “Under the so-called market reforms, many people in the developing world feel they have been swindled. After being sold on democracy, they are told that key decisions involving macroeconomic and monetary policy are too important to be left to political processes. The people can’t be trusted!

“Central banks must be independent, and they have been not only independent but unrepresentative - only financial interests and perspectives have had a voice.”

“Worse still, countries are told they must open up their market to short-term speculative capital - doing so, it is contended, will provide discipline. Hardly hidden in such statements [is] a distrust of democratic processes: electoral processes themselves apparently do not provide the discipline required for good economic decision-making.... The consequences for a country’s ability to exercise the democratic will are now being evidenced by the problems in Brazil. Is there a new tyranny of international financial markets, with even less sympathy for the plight of the poor?”

The financial markets, and the IMF which often represents their interests and ideology, often act as if there was a single Pareto (optimum outcome) dominant set of policies. But one of the first lessons taught in economics is of the existence of tradeoffs, and the role of the economic adviser is to lay out those tradeoffs. Economic science emphasizes the limits of knowledge, the uncertainties associated not only with the future, but the consequences of alternative actions, identifying not only gains and losses from each policy but also who bears the risks.

“The role of the political process is to make the choices, aware of tradeoffs, aware that some gain from some policy and others lose, that some policies involve more risks and some less, and that some policies involve certain groups bearing those risks. There are tradeoffs in the short run and the long. When outside advisers try to sell a particular policy as the right policy - implying there are no tradeoffs, no risks, no alternatives - governments and the citizens should rightly be suspect.”

Advocates of American-style capitalism have acted as if there is a single dominant form of economic organization. Though recent events have taken some of the sheen off capitalism American-style, the crusaders have never really understood the American economic system and what made it work, nor that of other countries. They have under-appreciated the role of government - for instance of industrial policies, from agriculture to hi-tech, from creation of the telecom industry in 1842 with the laying down of the first telegraph line to the modern Internet, or the regulatory policies so important for the functioning of the securities market and the banking system - and even underestimated the role of non-governmental and non-profit institutions, whether credit and agricultural cooperatives or universities, hospitals and foundations.

They have similarly underestimated the success of alternative versions of capitalism, such as those presented by Sweden, misrepresenting the reforms of the early 90s there as abandonment of the traditional welfare model. The success of the Swedish model, for example, is due to strong social protection, the strong safety nets to enhance the ability of individuals to take risks, and the realization that true democracy means more than just periodic elections. “Citizens have the right to know, and governments must be transparent.”

Electoral democracy, where elections are bought, where the media is controlled by certain special interests, or even where citizens do not have the knowledge required to be informed voters, may itself not be enough.

“What are those in Venezuela - where two-thirds of the population remain poor in an oil-rich country, and where the fruits of their rich endowment have flowed to particular groups - to think about an electoral democracy which, at least before the advent of Chavez, simply perpetuated this state of affairs?”

“Throughout the region today, those disenfranchised in the past are demanding a voice. The electoral democracies of the past have not improved their plight. That is what they know.”

These are the failures of the reform process that have to be confronted, Stiglitz said. (SUNS5186)                                 

From Third World Economics No. 288 (1-15 September 2002)