New economic reform agenda should promote development

Condemning the market fundamentalism of the Washington Consensus, Nobel economics laureate Joseph Stiglitz has outlined the need for a new agenda for economic reform which is tailored to the particular conditions and contexts facing each country. This agenda, Stiglitz envisioned in a recent lecture, would assign a key role to government in economic stewardship and aim at social mobilization, ensuring equity and creating a conducive environment for domestic as much as foreign enterprise.

by Chakravarthi Raghavan

GENEVA: A new agenda for economic reform in Latin America should effectively promote development which involves transformation of society and not be trapped in the narrow vision of the failed neoliberal reform agenda, according to Joseph Stiglitz, Nobel laureate, former Vice-President of the World Bank and now Professor of Economics at Columbia University.

Such a reform agenda cannot be a single, one-size-fits-all approach, for which the Washington Consensus was rightly blamed, but should be fashioned to enable each country to choose the alternatives appropriate to its conditions and people and with elements involving social mobilization, ensuring equity, and creating an environment good for business - domestic as much as foreign - declared Stiglitz at the Prebisch lecture on 26 August at the Economic Commission for Latin America and the Caribbean (ECLAC) in Santiago.

The neoliberal reform agenda (of the Washington Consensus) had failed even in its most narrow objectives of promoting economic growth, not because of faulty implementation but because of fundamental flaws in its concept, Stiglitz said. [An article on Stiglitz’s examination, in his lecture, of the failure of the neoliberal reforms in Latin America appeared in the previous issue of  TWE (“Failure of economic reforms due to fundamental flaws in design”).]

The Washington Consensus was “both misguided in its priorities and wrong in its ‘model’ of the economy.” It had confused the means - liberalization, privatization, stabilization - with ends.

Its focus should have been on democratic, equitable and sustainable development. And it should have recognized that “while markets may be at the centre of a successful economy, government had to play an important role.”

One of the great problems in Latin America, Stiglitz said, is the persistence of a high level of inequality. “Markets, by themselves, will not deal with this problem, and the trickle-down economics of market fundamentalists simply does not work; and, even when it works, it works too slowly.”

If one looked at what was not on the agenda of the Washington Consensus, one could get a better idea of the role of ideology and the interests behind it. For example, share-cropping, with often 50% of the output turned over to the landlord, was a prevalent form of agriculture, and its adverse effects on the poor are important. However, while the IMF speaks out forcefully against high taxes for reducing incentives, land reforms have not made it into the IMF agenda.

Failure of market fundamentalism

The scandals facing corporate America today have shown the dangers of unregulated markets, and show that “incentives work, but not necessarily in the interests either of the economy as a whole or even the ordinary shareholder.”

The US corporate scandals “are the consequence of the same deregulation mantra” that was pushed in Latin America, Stiglitz noted. America should have learned the lessons of “excessive deregulation of the financial system” under (President Ronald) Reagan. This, combined with the excessively high interest rates, had led to the savings-and-loans debacle, costing not only the US taxpayer billions, but the American economy even more, through misallocated investment.

Underlying market fundamentalism is the belief in the invisible hand, the efficiency of unfettered markets. But with imperfect information and incomplete markets, problems particularly relevant in developing countries, “the invisible hand may be invisible simply because it is not there.”

Market failures are rife and, even when there are several firms in a market, limited information may give each a certain degree of monopoly power, often the case in lending markets, especially to small and medium size enterprises, and in marketing in agriculture, especially in very underdeveloped countries. This is one of the reasons why even in the United States, they did not rely on private firms for marketing of many agricultural products, from raisins to oranges, but instead resorted to cooperatives; and it is also why lending cooperatives have traditionally played such an important role. As the international economic institutions have demanded the abandonment of marketing boards in several west African countries, there is the worry that farmers have benefited little; money that used to go to help pay for general government services, and in some cases went to corruption, now goes to support local monopolies and mafia and more local corruption.

“There are no general theorems (in economics) that say that liberalization and privatization in the kind of imperfect world in which we live will lead to improvements in overall societal welfare. There are theorems which have shown that trade liberalization in the presence of imperfect risk markets may actually make everyone worse off, and that show that the only conditions under which one can be sure that privatization will be welfare-enhancing are the same highly restrictive conditions under which Adam Smith’s invisible hand is valid.”

Empirical research is supportive of this sceptical approach, Stiglitz said, citing the research work of Francisco Rodriguez and Dani Rodrik (NBER research paper 1999) in the area of trade and of Dani Rodrik in the case of capital market liberalization (showing it leads neither to increased growth nor to more investment).

While it made sense for government to get out of areas like steel, “in areas like water, electricity, transport and gas, in which government in one form or other has to play a major role”, the problems of regulation and deregulation that have come to light, for example in California and the UK and in several cases in Latin America, “demonstrate that privatization is no panacea, and may actually make matters worse; and the process of privatization, especially when pushed excessively rapidly, itself is fraught with problems.”

Market fundamentalism fares no better at the macroeconomic level than at the micro, and partly because of the failure to appreciate the links between the two. The Washington Consensus policies have not only not succeeded in achieving macro-stability, but have actually contributed to instability through policies of capital and financial market liberalization, and by confusing ends with means. While inflation, particularly very high rates of inflation, can impede economic growth, actions taken to limit inflation may themselves have adverse effects on growth, in which case the two have to be balanced off.

There is some evidence that excessive focus on inflation has stifled growth. While he was not advocating unbridled inflation, when a country has large underutilized resources and is under deflation, “one should not make a fetish in worrying ... that some degree of fiscal expansion might lead to slightly higher prices,” Stiglitz said. When a country like Bolivia is about to gain access to large flows of resources as a result of sale of natural gas, there is no reason to argue it should not draw upon its future wealth to help stimulate the economy.

“There is a need to formulate a set of economic policies that reflect a better balance between markets and government, that recognize the critical role that both must play if the economy is to function, that recognize that roles will change over time, depending on the strengths of institutions in both the public and private sector, that recognize that development strategies must focus on simultaneously strengthening both.

“We need too to shift our focus away from an excessive focus on inflation to focusing on job creation; from restructuring and privatizing existing enterprises to creating new ones. We need to move away from a belief in trickle-down economics (or even from modern renditions, the “trickle down plus”, which add to the simplistic Washington Consensus a concern for primary education, especially for girls) to an explicit focus on poverty in all of its dimensions, and a recognition that one cannot separate out economic policies from their social and political context.”

Development represents a transformation of society. The Washington Consensus simply ignored these dimensions. “Somehow, it believed that if markets could be allowed to work by themselves, countries would develop. That has not happened, and it has never happened. But by encouraging, forcing countries to focus on a narrow economic agenda ... it took attention away from the broader goals of societal reform, in which land reform, education, political and economic rights would have featured more prominently.”

Risks of foreign borrowing

One adverse consequence of these misguided ideas was that “it led countries to the view that if only they could get more capital, they would grow more rapidly.... If they could not generate savings at home ... then they should turn to foreigners.” The argument was simple: so long as the return exceeded the interest rate paid, then the investment was a good investment - there were profits. And it did not make much difference whether that capital was short-term or long.

There were several things wrong with this line of reasoning. In part, it underestimated the cost of the funds, borrowing in dollars if the interest rates were lower. But governments (and the private sector, both lenders and borrowers) systematically underestimated the risk of exchange rate fluctuations and the consequences. In country after country, what began as moderate levels of foreign indebtedness wound up being unbearable levels as a result of depreciations.

The willingness to borrow with short-term financing was particularly misguided. Prudence today requires that countries maintain reserves equal to their short-term foreign-denominated debt. This means that if a country borrows $100 million it must set aside that amount in reserves - $100 million of public money that could have been used to build schools or highways. While it gets a return on the reserves, the country as a whole is worse off, for the reserves are typically held in the form of dollar Treasury bills, earning say today less than 2%, while paying the American bank 18% or more. The net cost to the country is $16 million, a net transfer from the poor developing country to the United States.

“It may be good for growth in the US, but it is hard to see how it is good for growth in the poor developing countries,” Stiglitz commented.

Finally, one of the most important errors was to underestimate the externalities associated with such borrowing when things go badly, as they did in East Asia and elsewhere. It was not only the borrowers that wound up bearing the costs, especially under the responses to the crises designed by the IMF. Though indirectly, the IMF recognized the presence of a market failure, in talking about contagion, it did not respond the way economists normally do to the identification of externalities, namely, by taxing short-term borrowing that created the externality.

Despite his best efforts, Stiglitz said, the IMF, and those advocating capital market liberalizaton and increased dependence on foreign borrowing, have refused to enter into such arguments. However, in developing countries and emerging markets, there is now an increasing recognition of the risks to which foreign borrowing exposes a country, and that the gains do not compensate them for the losses experienced in the event of a crisis, which happens with such frequency and regularity. Even the traditional argument that countries need to maintain access to international capital markets was losing its persuasiveness.

“Typically in these times of crisis, when countries are in desperate need, all that is at issue is how much money the country will send back to the United States and the other advanced industrial countries. The net flow is out of the country, not into the country, the same as the situation in Latin America during the lost decade.”

Social mobilization

Outlining some elements of a reform agenda, Stiglitz put foremost “social mobilization”, stressing education as its most important element. While increasing expenditures on education has become part of the mantra of both the left and the right, less attention, he complained, was paid to issues of the allocation of educational expenditures and content. In many of the poorer countries, for at least the next quarter-century, large fractions of the population will remain on the farms and for these, education needs not only to be a way out but a way up, not just training for urban jobs but skills to increase productivity within the rural sector. Knowledge about health and the environment too could have immense effect on the quality of everyday life, on the sustainability of the environment, and even long-run living standards. Entrepreneurship, as well as the other skills and knowledge for success in business, too can be taught.

In some developing countries, micro-credit schemes have proved to be an important instrument for social mobilization. While much of the discussion of micro-credit has emphasized the economic aspects, the provision of credit to poor households, especially poor women, who otherwise would not have access, much more was at stake, including overturning power structures in local villages and ensuring more economic power to poor women.

The media can play an important role, but not if it is controlled by a few wealthy individuals and is heavily concentrated, as is the case in many countries. In such cases, government has to pass and enforce legislation ensuring media diversification, and ensure that more voices are heard over the media, e.g., through the support of community radio stations and radio stations controlled by NGOs.

While good environment has been viewed as a luxury of the rich but one which the poor cannot afford, in many instances, growth, poverty reduction and the protection of the environment are complements. In many parts of the world, communities have traditionally found ways of managing the environment for the common good. The tragedy of the commons, sometimes portrayed as the failure to establish well-defined property rights over common resources, “is, too often, the result of the intrusion of (imperfect) market forces into traditional cultures.”

Culture is also an important ingredient of social mobilization.

Equity

On issues of equity, Stiglitz said that poverty was given short shrift in the Washington Consensus, perhaps because it was believed that the benefits of growth would eventually trickle down. But there is little reason to believe that that is the case. And, the Washington Consensus policies almost surely made problems of poverty worse.

The first item in an anti-poverty agenda should be the commitment by the government to the creation of jobs, of decent work, for everyone, the fundamental right of everyone in society who is willing to work to have a job. And it is the fundamental responsibility of government to ensure that those rights are fulfilled. Any government that fails, fails miserably, should lose its mandate.

Thus, there needs to be a shift from the single-minded focus on fighting inflation to promoting growth and job creation, including focus on the impediments - lack of credit and overvalued exchange rates. If macroeconomic management leads to overvalued exchange rates and high interest rates, there will not be job creation.

Also, capital markets are not like ordinary markets, in which efficiency requires a “single price”. In all countries, government has played an important role in providing credit to students, for home finance, for farmers, for small and medium size businesses, for exports. While these programmes have sometimes been abused, how to provide protections against these abuses is now better known.

Promoting equity and fighting poverty has to begin with education and health programmes for children, but it has to be lifelong. Success in the fight for equity and against poverty requires economic empowerment as well as political empowerment.

In the rural sector, this will entail land reform, meaningful land reform that accompanies land redistribution with the provision of credit and access to technology. Land registration is important, but it has to be seen as only one component of a broader programme. Land registration enhances the use of land as collateral, but it will be effective only where there are well-functioning land markets.

In both the rural and the urban sectors, there have to be programmes to promote savings. Recent collapses of banking systems may have eroded confidence in the financial sector. There is a need to look for ways of providing credible government guarantees for small savers, and an awareness of this issue of confidence should affect strategies for bank restructuring in countries in crisis.

One possibility to encourage the use of domestic financial institutions is to have some government matching of savings for small savings accounts (a form of cashable “earned income tax credit” for savings for low-income individuals).

Taxation has to be made more equitable. The VAT is not an equitable tax; and in most developing countries it is a tax that is neither consistent with economic efficiency nor does it promote growth, for it is a tax on the formal sector. And since the very wealthy often spend substantial sums of income abroad, it does not even represent a proportional tax on consumption.

Tax policy should be aimed at promoting equity, stability and sustainable growth; and one should look for corruption-resistant tax structures - relying more heavily on indirect taxes, like those imposed on large cars and luxury consumption goods, consumed largely by the rich (and largely imported). Commodities like oil and coal which are bad for the environment should be taxed, imposing higher taxes on rents, such as those associated with natural resources.

There should be highly progressive taxes on large houses and large holdings of land; and ways thought of on how to induce landholders to hire more labour, such as by giving a tax deduction or credit for the hiring of workers.

Stiglitz also advocated taxing flows of short-term capital into and out of a country, adjusting the tax rate to the economic circumstances. Also, other measures could be used to stabilize capital flows and reduce exposure, like provisions affecting the tax deductibility of short-term foreign denominated debt, and bank regulations to discourage short-term foreign denominated liabilities, which seem to generate such large externalities.

Supporting domestic business

In terms of creating an environment that is good for business (a standard fare though paying attention only to what attracts foreign investors), Stiglitz underscored the need for a hospitable environment for domestic investors.

The countries that have fared best in Europe recently, such as Ireland and Portugal, he noted, have had strong, well-regulated, local banking systems and good educational systems. In the 19^th and 20^th centuries in the US, a great deal of emphasis was placed on local banks, and there was a legitimate worry that a concentrated banking system, centred in New York, would drain resources away from the rest of the country and impede broad development.

It was not until the 1990s that national banking was allowed in the US. “Yet internationally, we have insisted that small countries open themselves up to international banks, with little attention paid to whether these banks will provide credit for small and medium size firms.”

Argentina has shown that having international banks does not ensure the stability of the banking system. Some thought that the “mother banks” would come to the rescue of their subsidiaries; certainly many depositors seemed to have been led to that belief. But that has not occurred. To level the playing field and to promote growth, there is a need to impose something analogous to the Community Reinvestment Act - “banks which garner resources in a country must re-lend the money within that country, and significant portions to small and medium size domestic enterprises.”

Since they can stifle business, regulations have to be re-examined, recognizing that the objective should not be deregulation but finding the right regulatory framework, one which makes the market economy work and minimizes unnecessary regulatory burden, e.g., by providing one-stop centres. Regulatory uncertainty and corruption, often associated with regulatory discretion, has been shown to be an important impediment to business. “There are ways by which corruption can be monitored, and strategies used for reducing it. However, corruption, as we are learning (from US corporate scandals), can occur in the private sector as well as in the public, and transparency can be at least a partially effective antidote against corruption.”

Macro-stability is critical for maintaining a good business environment. But maintaining stability in the face of the highly unstable environment, with huge fluctuations in exchange rates and commodity prices, will not be easy. Countries will need to learn how to manage these risks, including through commodity diversification, the creation of stabilization funds, the use of counter-cyclical tax and credit (not just monetary) policies, and modulating short-term capital flows.

The hallmark of the earlier period of success in Latin America was industrial policies. Such policies have, in the course of the past quarter-century, unjustifiably obtained a bad reputation. But policies that worked in one era may be less effective in another, and the global trading regime has imposed limitations on the extent to which governments can make use of some of the standard techniques even if they would have liked to have done so.

While such policies can be abused, some of the ways to reduce abuse and increase the likelihood of success are also known now. The Clinton administration in the US believed strongly that such policies could play an important role in the advancement of the American economy; and there was an even more compelling case for developing countries to use such policies, Stiglitz said.

“The fact that the US Treasury was more sympathetic to large bailouts for Wall Street or certain other items of corporate welfare than for forms of market intervention that promote technology, either at home or abroad, says more about the role of interests and the impurity of ideology than it does about the wisdom of certain economic policies.”

Government has in the past, and can in the future, play a catalytic role, to make markets work better, shape the economy, most importantly, through the physical, institutional and educational infrastructure. Part of that catalytic role in today’s economy is to help promote the recognition of the changes in structure that have been occurring through the world - the reduction in the manufacturing sector, the growth of the service sector, the ability of services to move across borders as well as goods.

The countries that have had the most rapid growth in the last decade and the most employment creation have been those that have accommodated themselves to and even supported these changes.

There are many other issues too: for example, the transportation systems, especially in rural areas, may have to be improved if individuals in the rural sector are to have access to markets. In some cases, there are “missing markets” or competition is so limited that small producers are exploited. In these instances, government should consider promoting rural cooperatives. Privatization and liberalization also need to be reformed.

While he had focussed his remarks on what the countries of the region can do, given the current international regime, that regime has fundamental problems. “There were well-documented inequities in the global trading regimes; and the global financial regime is not only inequitable, but it is inherently unstable.”

While taking advantage of globalization, countries of the region also should seek to shape globalization on their own terms. A Free Trade Area of the Americas could be of enormous benefit to the countries of the region, “but only if America truly opens up its markets, all of its markets, to the goods of the region, which means not only open up its agricultural and textile markets, but eliminating agricultural subsidies, and foregoing the myriad of non-tariff barriers which the United States has employed even against its neighbours Canada and Mexico.”

And a free trade agreement cannot be used to promote policies, under the rubric of “investment protections”, that would be otherwise unacceptable, or an unbalanced intellectual property regime (as was arguably the case under the Uruguay Round). (SUNS5189)                      

The full text of Prof Stiglitz’s address can be found on the ECLAC website, www.eclac.org

From Third World Economics No. 289 (16-30 September 2002)