This reasoning was appealing. I used to believe in shock therapy and structural adjustment. We proponents of such comprehensive reforms convinced ourselves at the time that partial reform would not work unless all of the complementary reforms happened quickly and simultaneously. Sometimes we clinched the argument with a metaphor like “You can’t cross a chasm in two leaps.” It seemed plausible that the returns on small interventions would be low if the whole economic and political system was messed up—hence the attempt to remake the system in one fell swoop.
What we shock therapists didn’t realize was that all reforms are partial; it is impossible to do everything at once, and no policymaker has enough information even to know what “everything” is. The choice is between large-scale partial reforms (which shock therapy mislabels as comprehensive reforms) and small-scale partial reforms. Either large-scale or small-scale partial reforms could backfire, but it is much easier to correct the small mistakes than the large mistakes. The “unintended consequences” problem is greater with a large-scale reform than with a smaller one. The attempted changes at the top are out of touch with the complexity at the bottom, as we will see in this chapter. To make a long story short, the shock therapy often ran afoul of poor institutions that failed to prevent public corruption and private looting. The overambitious reforms of shock therapy and structural adjustment were the flight of Icarus for the World Bank and the IMF. Aiming for the sun, they instead descended into a sea of failure.
The World Bank and the IMF gave Côte d’Ivoire twenty-six structural adjustment loans in the 1980s and 1990s. Per capita income in the country plunged throughout the period in one of the worst and longest depressions in economic history. Today, Côte d’Ivoire is mired in civil war. Indeed, it’s a little unnerving that almost all recent cases of collapses into anarchy were preceded by heavy World Bank and IMF involvement. Although I don’t think the IMF and the World Bank caused the Ivorian collapse into anarchy, it would be hard to argue that their involvement in the country had a positive long-run effect.
I have picked out the African countries that were in the top twenty worldwide in the number of structural adjustment loans received from the World Bank and the IMF. Most African countries that received intensive treatment from structural adjustment have had negative or zero growth. I have also listed the top ten recipients of structural adjustment loans in the ex-Communist countries. Most ex-Communist countries that received shock therapy and many structural adjustment loans have had sharply negative growth and high inflation (see table 2).
On balance, the outcomes associated with frequent structural adjustment lending are poor. Using the methods of evaluation mentioned earlier, one finds that, first, things were so bad in so many countries that were recipients of structural adjustment loans that it stretches belief that the loans had a strong positive effect. Second, since structural adjustment loans were repeated year after year, one wonders why the patient did not improve after repeated doses of the medicine. Finally, formal statistical methods to control for possible reverse causality from crisis to treatment still found that structural adjustment lending has had a zero or negative effect on economic growth.12 Another influential recent study by Adam Przeworski of New York University and James Vreeland of Yale found that the effect of IMF programs on growth was negative, even when the study controlled for the adverse-selection effect. Another piece of evidence: as we see in a later chapter, African countries (even the “success stories”) couldn’t pay back zero-interest structural adjustment loans, and the World Bank and IMF had to forgive the debts. The White Man’s Burden was deployed in other ex-Communist countries of Eastern Europe and the former Soviet Union besides Russia. These countries themselves technically had white people, but the Western whites were convinced they had missionary gifts for their Eastern counterparts. Unfortunately, the attempted leap across the chasm fell a little short of the other side, as shown in figure 4, aside from the Polish success story. It’s hard to know how to attribute blame for this disaster, but clearly the high expectations of the Western reformers were not realized.
Fig. 4. Growth Trajectory in 1990s of Intensive Structural-Adjustment-Lending Ex-Communist Cases
Another region where there was great hope for comprehensive reform was Latin America, which had followed a regime of state intervention and restrictions on free trade from the 1950s through the 1970s. After the debt crisis of the early 1980s, in which Latin American countries were cut off from access to new loans from international private banks, the countries started moving toward free markets. As usual, structural adjustment loans from the World Bank and IMF supported these comprehensive reforms. One widely used index shows increasing economic freedom from 1985 to 2000 on average in Latin America (see figure 5).
Fig. 5. Economic Freedom Index in Latin America
Unfortunately, the comprehensive reform in Latin America has not been accompanied by economic growth. Ironically for structural adjustment proponents, the best period for Latin American growth was in the period of state intervention, 1950–1980. If that growth had continued, income in Latin America would now be three times higher than it was in 1950. Instead, in 2003, income there was barely twice the level of a half century earlier, with little progress made over 1980–2003 (see figure 6). The backlash against free markets is unfortunately now gaining strength in Latin America, with free markets tarnished by the utopian expectations of structural adjustment.
Fig. 6. Per Capita Income Index in Latin America (Log Base 2 Scale,* 1950 = 1): Actual and Trend, 1950–2003
So we have three regions where there were great hopes for structural adjustment and shock therapy—Africa, the former Communist countries, and Latin America—and three regions where those hopes were dashed. What was the West’s response?
The response to failure was to do more of the same. The IMF and World Bank kept on giving out structural adjustment loans for more than two decades, despite their record of failure. Today, they are still doing those loans; they have just changed their name to “poverty reduction loans.” This is the fixation-on-a-big-goal characteristic of Planners, despite repeated failures to reach the goal.
I’m Hungry—Let’s Invent Free Markets
The free market is a universally useful system. Economic freedom is one of mankind’s most underrated inventions, much less publicized than its cousin political freedom. Economic freedom just means unrestricted rights to produce, buy, and sell. Each of us can choose the things we want and not have somebody else decide what is best for us. We can also freely choose what we are going to sell and what occupation to choose, based on our inside knowledge of what we are best at and most like doing.
This freedom of choice and of personal knowledge makes possible the great gains that come from specialization. If I were limited to my consuming only what I could make or do myself, the results would not be pretty. My cooking skills are limited, for example, as my kids will attest. Rachel, Caleb, and Grace long ago got tired of my staple menu items of boiled spaghetti, macaroni and cheese, and rice and beans. Hence, we rely on the historic market innovation of takeout, which opens up to us a wonderful world of bagels, pizza, and rich cuisines from cultures such as China, Ethiopia, Japan, Thailand, Vietnam, and Tex-Mexico. Even when we are stuck with my cooking repertoire, this still depends on my purchasing pasta, cheese, rice, and beans from supermarkets. Without markets, I would be forced to grow the wheat, beans, and rice myself, milk the cow, process the grains and beans into edible form, and make the cheese and pasta. (I have no clue how to do any of the above.) Instead, I trade on the free market my economist services (which inexplicably find some buyers at New York University) and get money in return. I use this money to select home cooking items and to order takeout.
Adam Smith celebrated specialization in The Wealth of Nations in 1776. Each of us has some innate advantages in doing some things and innate disadvantages in doing others. Market exchange makes it possible for us to determine what we are good at, to specialize in producing it
, and to trade it for other things produced by people good at producing those things. This applies to nations as well as individuals, which is part of the intellectual case for free trade. As an old joke has it, heaven is where the chefs are French, the police are British, the lovers are Italian, and the car mechanics are German—and it is all organized by the Swiss. Hell is where the chefs are British, the police are German, the lovers are Swiss, and the car mechanics are French—and it is all organized by the Italians.
Specialization doesn’t necessarily involve innate abilities. This awful joke became an awful joke because we see some national differences (although I can’t necessarily verify the ones implied above), but don’t really believe these differences are innate. The French don’t have any gene that makes them wonderful cooks or lousy car mechanics; but they have refined their culinary tradition from one generation to the next. This also applies to individuals. You learn by doing. As each person does a task repeatedly, practice makes perfect, no matter whether that task is playing Mozart sonatas or nailing shingles to a roof. As each of us specializes and then trades our final products with one another, we all become better off.
The other great accomplishment of markets is that they reconcile the choices people make for themselves with the choices other people are making. Back at the dinner table we find that no Planner is necessary to process the enormous amount of information required to decide how much pasta, rice, cheese, and takeout cuisines of various cultures to supply to the people of New York. This great achievement of markets is achieved through Searchers. The suppliers search for customers, the customers search for suppliers, and the price adjusts up or down to equate supply and demand. So the market determines prices and quantities to reconcile the needs and abilities of suppliers and consumers. The price reflects both the additional cost that the supplier incurs to supply an additional item and the additional benefit that the consumer gets from purchasing one more of each item. Hence, the market matches the additional cost to society of producing each item to the additional benefit to society of consuming that item. The market comes up with a basket of commodities produced at the lowest possible price for the highest possible benefit. Economists have mathematical proofs that show that, under certain conditions, free markets lead to the best possible allocation of the economy’s resources for everyone—given each person’s initial stock of possessions. (Of course, it is disturbing that some people have tinier endowments than others; I will get to that later.) Adam Smith celebrated the social good achieved in this system, even though each of us is operating out of self-interest.
The West often awards itself credit for having invented the market. This is nonsense. Any visit to an outdoor market in Africa, Asia, the Middle East, or Latin America will quickly convince you that markets are vibrant in poor countries. Historical anecdotes suggest that these markets predated Western contact.
And market instincts are hardwired into human nature. As any parent knows, children understand the concept of gains from trade early on. The first thing that Rachel, Caleb, and Grace did after the neighborhood Easter egg hunt when they were young was empty out their candy and start trading—Rachel likes dark chocolate, Grace likes milk chocolate, and Caleb likes peanut butter cups. When Tom Sawyer traded Huck Finn a pinch bug for a tooth, he was acting out of instinct, not MBA training.13
For some goods, the price the suppliers want is too high relative to what the consumers are willing to pay, and therefore suppliers don’t produce. There is no takeout market in New York for the Jell-O mixed with fruit cocktail and topped with marshmallows that my mother made when I was growing up in Bowling Green, Ohio. Unlike bagels, Jell-O doesn’t meet the market test that consumers are willing to pay a high enough price to cover the suppliers’ costs, and so we have bagel shops and no Jell-O shops.
Markets have potential for mutually beneficial trades. If an Ohioan has more bagels than he wants, and a New Yorker has more Jell-O than he wants, they are both better off if they trade bagels for Jell-O. The intensities of their desire for bagels and Jell-O and their holdings of bagels and Jell-O determined the terms of trade. Many critics of free markets miss this point—that any voluntary exchange makes both parties better off, although not necessarily to the same degree. Our sense of fairness is offended if the price seems too high for one party or the other—if a New Yorker has a lot of unwanted Jell-O and a high demand for bagels, then an Ohioan can drive what will look like a great bargain in getting a lot of Jell-O for his bagels. Still, even if the Ohioan benefits more than the New Yorker, they are both better off making the trade.
Consumer Searchers are always on the lookout for beneficial trades. Supplier Searchers are on the lookout for profitable products to supply. The market has no use for the Millennium Jell-O Plan.
Financial Markets Are Good, Too
How does the financial market come in to all this? Financial markets refute the common perception that what you can invest in the future is limited to your own funds. You can borrow to buy land or start a small business (this works less often than it should, but much more often than if financial markets didn’t exist). The beauty of financial markets is that they make high return investments available to everyone. This idea motivates the enthusiasm for microcredit schemes that reach destitute people, such as that of the Grameen Bank in Bangladesh.
Given that everyone can enter, financial markets equalize the returns (i.e., the percentage you get over and above repaying the cost of the original investment) to various types of investments across the economy. Anyone can enter any industry. If bagel stores have a high return, then many people will enter bagel retailing until they drive down the returns to normal levels. Any economy in which people do not equalize returns across all types of activities (getting an education, buying land, starting a small business, etc.) is not a free-market economy. It is also not making the most out of its stock of savings. You can see this by asking what would happen if you took money out of a low-return activity (Jell-O stores) and put it in a high-return activity (bagel stores). The value of output would go down by less in the Jell-O takeout industry than it would go up in bagels, and so the economy would produce more out of the same stock of savings. Anytime returns are unequal, such free gains in output are possible. Wall Street wizards, entrepreneurs, or Bill Gates search out any unusually high-return activities, and by investing in them, drive down their returns, while ruthlessly taking capital away from low-return activities. Again, no central bureau is in charge of investments—just myriad Searchers such as financial firms. Planners would do an awful job allocating money across sectors in the financial markets because they have no way of getting information on which sectors have high payoffs. There are many savers and investors, and financial firms play middlemen between the two.
So the bottom line is that financial markets (1) are a great source of free-market efficiency, and (2) create opportunities for anyone to get rich by borrowing and investing.
If we combine the virtues of goods markets and financial markets, we get a positive-feedback loop for any successful search to meet the needs of our fellow citizens. If we supply a product in high demand, we will reap high profits. Profits induce us to expand production, pulling workers and raw materials away from other products in less demand to produce the high-demand product. Outside investors want to share in the high returns, giving us more financing to expand our scale even more. An equally powerful incentive exists to invent a brand-new product to meet consumer needs. The positive-feedback loop to searching for solutions to customers’ problems has made the market the greatest bottom-up system in history for meeting people’s needs. (If only foreign aid could work like this!)
Not only that, but the common thread in the success stories of the last few decades—Hong Kong, Korea, Singapore, Taiwan, China, India, Chile, Botswana, etc.—is that the Searchers for success in each of these countries (which were often far from laissez-faire market economies) subjected their efforts to a market test, often through international markets. W
ould private foreign investors invest? Would the rest of the world buy what they were producing? The answer was yes, which gave the Searchers feedback to move in the direction of prosperity, although their paths toward market successes varied from the simplistic visions of shock therapy.
Bottom-up Problems with Markets
With this paean to the glories of the market, the question becomes why markets don’t make all societies rich. This book is not suggesting a simple recipe for national success; the point of this chapter is the opposite: no recipe exists, only a confusing welter of bottom-up social institutions and norms essential for markets. These evolve slowly on their own from the actions of many agents; the Western outsiders and Planners don’t have a clue how to create these norms and institutions.
Nor are markets of much help to those who are now very poor—after all, the poor have no money to motivate any market Searchers to meet their needs. The hope for the poor depends on the same dual forces this book emphasizes throughout: (1) homegrown, market-based development that will lift up both rich and poor (which this chapter further argues is way too complex a task for Western assistance); and (2) Western assistance for meeting the most desperate needs of the poor until homegrown market-based development reaches them. (Western assistance could also borrow some ideas from markets, such as eliciting feedback from customers.)
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