My theoretical research focused on the consequences of imperfect information and the inability of firms and households to fully insure themselves against important risks they faced. Standard economics, as it had developed from Adam Smith on, while not denying the importance of risk and information, had proceeded by assuming that a world in which, for instance, information imperfections were not too large would be well described by one in which information was imperfect. My work (together with that of a large number of other scholars working in this area)8 had shown that that assumption was false: even small amounts of information imperfection could have very large effects. Most importantly, the old theories assumed that normally there was full employment, that there was no credit rationing (no liquidity constraints, no constraints on borrowing), and that the outcome of competitive markets was efficient.9 These assumptions too were shown to be false.
My criticism of the Washington Consensus policies was in part that they were based on discredited economic theories. In its supporters’ minds was a clear view of what an economy should look like, the perfect market economy of elementary textbooks. They realized that all economies—and especially of developing countries—deviated from this ideal, but their policy agenda was to make actual markets as close to the competitive ideal as possible.
As chief economist of the World Bank, my main critique of this approach was pragmatic: it was essentially not working anywhere; and the countries that were successful were following a markedly different model. But my background as a theorist had led me to anticipate the failures of the Washington Consensus, as well as the successes of the development strategies of East Asia. There were two critical failings of the Washington Consensus policies. The first was that the “ideal” for which they were striving was bogus: no economy, ever, would have perfect information, so markets were inherently imperfect. The objective should have been to construct as well-performing an economy as one could, given limitations in information, the costs of setting up markets, the persistent irrationalities of individuals, etc.
The second critique went deeper, and was based on the Theory of the Second Best. Even before my work, it had been shown that even if it were true that an ideal perfect competition model led to efficiency, moving toward that might not make matters better. I illustrated this in chapter 1 with an example attacking standard presumptions in favor of trade liberalization: with imperfect risk markets, opening up trade could so increase risk that, to avoid the risk, firms would shift investments toward lower-productivity, safer investments, so much so that everyone could be worse off than they were before trade liberalization.10
Globalization and the set of problems that I confronted as chief economist of the World Bank, though, posed a set of new analytic challenges—situations that had not been confronted before. Countries had not before faced the daunting task of moving from communism to a market economy. Perhaps not since the Great Depression had there been a crisis of the magnitude of the East Asia crisis—with half or more of the firms in the region on the verge of bankruptcy. The best one could do in thinking about what were the right policies—to facilitate the transition or to combat the East Asia crisis—was to draw upon economic theory and what one could learn from similar experiences. That, in turn, required having a view about how the economic system as a whole behaves, and particularly how it behaves out of “equilibrium,” out of a normal state of affairs. Nothing could have been more exciting to an economic theorist than being confronted with hard, unsolved problems. And nothing could have been more frustrating than to have much of the policy debate dominated by those holding on to models which were clearly inappropriate to the situation.
Consider, for instance, the subject of short-term capital flows. The standard models in economics on which the Washington Consensus was based were clearly wrong: they predicted that these flows would be stabilizing, so that when a country had troubles, money would rush in to help it out. The evidence was to the contrary: when a problem was detected, money rushed out, exacerbating the downturn. (As I jokingly explained to my students, the first principle of banking is never to lend to anybody who really needs your money.)
New theories were required, and in GAID I tried to extend the standard theory, suggesting what such models might look like. A few years later, I published some of the underlying mathematics.11
The events I confronted led to the development of new areas of research, with results that often modified, and sometimes contradicted, longstanding policy dictums derived from the old models. Later in this afterword, I note a couple other examples.
THE BATTLES OVER POLICY
GAID describes a fundamental fight over economic theory and policy, played out in three battlefields: economies in transition, East Asian countries, and poor countries striving to develop.
The Washington Consensus
The Washington Consensus policies that I was arguing against12—focusing on privatization, deregulation, liberalization, and macrostability centered around fighting inflation—were, as I have suggested, predicated on a view that markets worked well and there was a limited role for government. Standard theory, dating back to Adam Smith,13 had argued that in perfect markets, the pursuit of self-interest by firms and households would lead, as if by an invisible hand, to the well-being of society. My theoretical research14 had explained why Adam Smith’s invisible hand was invisible—it wasn’t there. Whenever there was imperfect information or incomplete markets—as is always the case—there is a presumption that markets are inefficient and selective intervention can improve well-being. And my experience in developing countries, crisis countries, and countries in transition confirmed these theoretical insights.
Different economic views naturally translate into important differences in policy. Because my research had shown so clearly the limitations of markets, I was far more reluctant to rely just on markets, far more aware of the need for appropriately designed government policies.
By 2016, there was a growing consensus that the Washington Consensus policies were wrong—they often had the opposite effect from that intended. Rather than accelerating growth, they retarded development; rather than enhancing stability, they had helped usher in an era of unprecedented instability. There was a need for a new consensus.
A group of thirteen economists, including four former chief economists of the World Bank (including me), put together what we called the Stockholm Consensus, laying out ten principles of development policy, which included the need to make development inclusive, to attend to inequality, to make development environmentally sustainable, and to get the right balance between the market, the state, and civil society.15 The new consensus emphasized too that one-size-fits-all policies don’t work: there are large differences not only between developed and developing countries, but also among the developing countries, calling for nuanced and tailored policies.
In GAID, I criticize each of the central pillars of the Washington Consensus policy framework. The Washington Consensus argued for deregulation, including of the financial sector. I argued that such liberalization could lead to very costly economic volatility. In the aftermath of the 2008 crisis, few doubt that.
The Washington Consensus argued for privatization. I explained in GAID why privatizations often fail, in both developed16 and developing countries—and experiences since GAID in both developed countries (e.g., UK railroads) and developing countries (e.g., Chile’s pension funds and Mexico’s roads) have provided new examples of failed privatizations. In Mexico, the government had to spend nearly $8 billion to renationalize just part of the privatized highway system.17
And last, the Washington Consensus argued for trade liberalization. I argued that poorly managed trade liberalization would not lead to more growth and there could be many losers; now, the New Discontents in the advanced countries have made this conclusion abundantly clear.
Capital Controls
One of the fiercest battles GAID describes was over a particular aspect of financial deregulation: capital
flows across borders, when firms or individuals from one country invest in or lend to another. At the time, the elimination of restrictions on these flows was at the heart of IMF ideology: they wanted to be able to force other countries to open up their capital markets (what is called capital market liberalization), to allow money to move freely in and out. In GAID, I expressed skepticism. By 2009—with a crisis in Europe (Iceland)—the IMF began to change its mind. It allowed Iceland to impose capital controls. By 2010 it was in a full-scale retreat, eventually endorsing the idea of capital controls (or as they are now more euphemistically referred to, capital account management measures).
America’s ultralow interest rates proved to cause a strain on the global economy. We have a globally interconnected economy—a trend pushed by the United States—but in the conduct of its own policies, it steadfastly refused to consider the consequences of its actions (just as it seems to be doing now, after Trump assumed the presidency). In the 1980s, unprecedented high interest rates in the United States precipitated the Latin American debt crisis. In the aftermath of the 2008 crisis, unprecedented low interest rates led to a rush of money into developing countries, leading in turn to increases in their exchange rate and a loss of competitiveness of their export industries. The strains on their economies were palpable. Around the world, countries did what they could to restrain the flow of money into their countries—to stabilize their economies. These interventions included capital controls, and some countries sought the blessing of the IMF as it undertook unorthodox policies. The IMF reached a new “institutional” consensus in support of these policies.18
Risk, the Washington Consensus, Modern Economic Analysis, and Politics
The Washington Consensus position on capital market liberalization reflected an unquestioning belief in markets. Markets are the best way of managing risk, and liberalization allows them to do what they do best, the Washington argument went. Thus, advocates of liberalization believed that with liberalization, markets would be more stable. The historical evidence, as well as a growing body of theory, overwhelmingly refute this claim, and the 2008 crisis is simply one more example demonstrating that unfettered markets actually create risk, even if well-managed and well-regulated markets can help manage risk.
How then could so many have ignored the theory and evidence? The central message of GAID was that it was a combination of interests and ideology, each reinforcing the other. What has happened in the last fifteen years is consistent with this diagnosis. The responses to the global financial crisis were shaped by interests—the banks, long enamored of free-market ideology, easily put that aside as they clamored for a massive bailout of hundreds of billions of dollars. Interests and ideology resulted in not just the banks being saved, but also the bondholders and shareholders. When President Obama was asked why the United States had not followed what economic theory (and in some respects even U.S. law) suggested—following standard bankruptcy procedures, where depositors and institutions are protected, but shareholders and bondholders bear the costs before U.S. taxpayers—he responded with an appeal to ideology: that was the way of socialism. Of course, he was wrong: what the United States did was a violation of the basic rules of capitalism.19
Even though globalization was not the subject on the table, this episode, especially when combined with the failure to adequately help those losing their homes and jobs, has had a profound effect on attitudes toward government and globalization. For it reinforced the view that government and established elites could not be trusted and that the system was rigged, attitudes which opened up the way for demagogues like Trump preaching protectionism and inward-looking policies.
Macromanagement: The Hypocrisy Exposed by the Financial Crisis
The global financial crisis of 2008 not only undermined confidence in unfettered markets and established elites, it also exposed Western hypocrisy: in addressing the crisis, the United States and Europe pursued policies diametrically different to what they had imposed in East Asia and elsewhere—and the cast of characters even included some of the same individuals.20 For instance, in the East Asia crisis (as described in GAID), the IMF and the U.S. Treasury insisted that the countries raise interest rates, cut back spending, and not bail out the banks. (In Indonesia, the IMF’s poor management of the no-bailout policy caused a bank run that deepened the downturn in that country.)21
In the 2008 crisis, Europe and America instead brought interest rates down to zero rather than raise them to the exorbitant levels demanded of Korea and Indonesia. They vastly expanded government spending—causing unprecedented deficits. And they engaged in one of the most massive bailouts in the history of mankind—even though critics like me had pointed out that such bailouts were not necessary to resuscitate the economy.22
Even the diagnosis of the causes of the East Asia crisis by the West suggested hypocrisy: during the East Asia crisis, American lectures about transparency and good corporate governance flowed freely. Blame for the crisis was put on failures in these realms. Yet the 2008 crisis was caused by lack of transparency in the United States, including on the part of the very banks and bankers that had lectured them. The real culprit for the crisis was the Washington Consensus policies—especially the premature push for capital market liberalization. In the other dimensions which the Washington consensus had emphasized—low fiscal deficits, high national savings, and low inflation—East Asia received a grade of A+. Doing well in these areas was supposed to inoculate one against a crisis. It obviously didn’t.
Not surprisingly, all of this has left a bitter aftertaste for many who experienced the hardship unnecessarily imposed on Asia. And the fact that the West could be hard on small and less powerful states in the West, like Greece and Portugal, demanding unremitting austerity of them, while equally unjustifiable, provided cold comfort to those in East Asia who had suffered a decade earlier. It only reinforced the view of duplicity: one set of rules for the rich and powerful, another for the rest.
The Aftermath of Crisis
Even by the time I wrote GAID, it was clear that the East Asian countries were well on the road to recovery. The critics who had castigated them, pointing to deep flaws in their economic and political systems, were proven wrong. The countries would not have been able to recover so quickly if that had been the case. While they experienced growth at rates somewhat lower than the torrid numbers that had characterized the heyday of the East Asian miracle, they were still impressive—beyond what most thought was even possible a half century earlier: Korea’s economy in 2016 was some 84 percent larger than in 2000, Thailand’s, some 87 percent, Indonesia’s some 132 percent, and Malaysia’s, 111 percent.
The crisis showed the dangers of capital and financial market liberalization, even in relatively well-managed economies: money could flow in, then rapidly flow out, leaving havoc in its wake.
Among the most important consequences of the IMF/U.S. Treasury mismanagement of the East Asia crisis was the buildup of massive reserves by developing countries and emerging markets, as I noted in the introduction. The crisis had shown the dangers of not having enough reserves. A country could lose its economic sovereignty—and have economic conditions imposed on it that, however they might help the Western banks who had helped create the crisis, were devastating for the population.23
The buildup of reserves weakened global aggregate demand—money that could have been spent was put aside into reserves—and even contributed to the weakness of the American economy. It made it easier for the United States to be debt-dependent. And the inflow of money (the flip side of the buildup of reserves) led to a stronger dollar, hurting manufacturing and contributing to the New Discontents described in chapter 1.
Development—Ethiopia: A Case Study
When I went to the World Bank, I had expected to focus on the development of poor countries, not a crisis in East Asia. Ethiopia was the first country I visited after becoming chief economist of the World Bank—and the last I visited before leaving my position. It set up a tradit
ion that was subsequently followed by my successors.
The end of the Cold War changed the landscape in Africa. In Ethiopia, Meles Zenawi, leader of the Tigrayan People’s Liberation Front, quickly grasped the political implications and in 1991 pushed his forces to reach an end to the seventeen-year conflict that they waged against the regime of despot Mengistu Haile Mariam, one of the bloodiest and most ruthless in the world. Less than five years later, the country was trying to go beyond reconstruction to create a dynamic economy based on rural development. But it ran into the ideological taskmasters at the IMF, who didn’t like that the country was forging its way forward without obeying IMF ideology.
As I explain in GAID, when I visited the country, in early 1997, and again in 1998, I was impressed: they had a clear grasp of the economics of their situation, and in most of the key issues under dispute between the IMF and the government of Ethiopia, I thought Ethiopia was in the right. The IMF was sufficiently critical that it curtailed its program in Ethiopia; and normally, that’s the kiss of death: other multilateral institutions won’t lend to a country that doesn’t have an IMF program in good standing. They worry that the money they give or lend the country will simply “go down the drain.” But I thought otherwise, and persuaded the World Bank—in a major break with precedent—to triple its lending.
What happened subsequently showed that my confidence in Ethiopia was fully justified. Over the period from 2000 to 2016, Ethiopia was one of the fastest-growing countries in the world, growing at a rate of 9 percent annually,24 better than most of the East Asian countries in their heyday. It studied carefully the development model of East Asia in which the government played a central role, so important that it was sometimes referred to as a “development state.” It used industrial policies and, using those policies, developed some vibrant new export industries, such as shoes. Other countries, such as Rwanda, looked toward the success of East Asia and the development state, to get similar results. It appeared that the East Asian model—a very different model than the Washington Consensus model—actually worked even in a quite different context.25
Globalization and Its Discontents Revisited Page 47