Sunday, November 22, 2009

The Big Swindle

The collapse of the Berlin wall in 1989 attested to the untenability of socialism as a way of organising productive forces in society. In the West, a similar decline in Keynesian economics had been taking place. The emergent paradigm came to be known as the Washington Consensus (WC), a term coined by John Williamson referring to the ten universal principles for encouraging growth and prosperity.

These principles were anchored on a faith in unfettered markets and a reduced role for government through liberalisation, privatisation and macro-stability. While they were intended to form the lowest common denominator for policy prescriptions, as Williamson later observed, they became a panacea, sufficient in and of themselves to cause economic transformation.

As it later became evident from the experiences of Russia, Sub-Saharan Africa and Latin America which had experimented with "market fundamentalism" or neoliberalism in the 1990s, the link between these reforms and economic growth seemed to be weak or untenable at best.

Meanwhile, economies like China and India which had used a hybrid approach involving private joint ventures with town and village enterprises (in the case of the former) or had engaged in selective deregulation (in the case of the latter) did extremely well. Decades earlier, Japan, Korea and Taiwan had engaged in industrial policy and currency devaluation, clearly distorting product and money markets, and saw their populations rise out of poverty within a generation.

What is worse, capital market liberalisation, an important WC tenet, apparently made Southeast Asian economies vulnerable to speculative attacks as demonstrated in 1997 with the Asian financial meltdown. In order to rescue the reputation of the economic doctrine, a renewed focus was placed on the role of governance, institutions and corruption something that the WC had hitherto ignored.

Ten additional principles covering these areas rounded out what was termed the Washington Consensus Plus. Never mind that an earlier financial crisis had erupted in Scandinavia where countries have an unrivalled reputation for transparency in government or that bureaucratic corruption had not prevented Korea or China from developing quite rapidly.

If the thesis had previously hinged on "getting the price right", it now depended on "getting institutions right" to deal with "noise" in the form of non-productive transactions costs that prevent markets from functioning properly. Institutional determinants (property rights, contract law, juducial capacity) were given the same level of concern that political considerations had earlier occupied (democracy v authoritarianism). It was observed however that no matter what developing countries did, the list of reforms and explanations for why they did not subsequently grow just kept getting longer and longer*.

The one democratic country that had comprehensively applied the principles of the Washington Consensus Plus and had developed from it was Australia. Since the 1980s, successive governments instituted reforms in the economy and governance. When the dot com crash of 2001 and global financial crisis of 2008 hit, local banks were innoculated from it through prudential regulation and supervision. By adapting the book title of one famous Peruvian author, this episode could be called, "Why the Washington Consensus works in Australia and fails everywhere else" for even America had resisted the need for transparency in exotic derivatives markets or prudential regulation over its banks.

When the bubble that was the US realty-derivative market burst, weaknesses were exposed in its political economy. As Simon Johnson noted (Johnson being part of the trio including Acemoglu and Robinson or "AJR" that first highlighted the importance of institutional determinants), Washington had become captive to Wall Street in a manner that was characteristic of many developing countries. This would suggest that the US ought not grow as fast into the future, something that recent developments seem to confirm.

It is interesting to note that from Australia, the jurisdiction that provides the ultimate case for the successful and bi-partisan application of neoliberalism its leader should have screamed the loudest for an alternative social democratic paradigm with protestations that "the Emperor has no clothes". In practice it has meant adopting a kind of Millenium Challenge approach through its domestic social and labour market policies enforced through a "cooperative Federalism".

One could challenge this approach as an alternative to the Washington Consensus, but the problem is what else would one then substitute it with? Development economists are in a state of confusion about the way forward. There are it would seem many paths to prosperity, not just one. But for countries already on that road, a key question is how to build on it.

An important study that illuminates this question was performed by Gustav Ranis in 2000. He showed that countries pursuing economic growth as their paramount objective may wind up in a development rut, but for those countries that pursued human capital development, a virtuous cycle that involved both growth and improved human well-being ultimately occurred.

Although it would seem straight-forward and self-evident to take the conclusions of the study and recommend investing a greater share of GDP to human services as what Jeffrey Sachs and the UN Millenium Challenge Project would prefer, the same old questions crop up. Namely, would not improvements in governance be more helpful? How would local institutions, cultural and social norms interact with the resulting programs? Should governments or private markets take the lead?

Just as the "death" of god led to his resurrection in the form of "structure", the decline of neoliberalism is bringing about its rebirth in other deterministic forms.

* Perhaps instituting structural reforms is not the answer if it eventually weakens the legitimacy and capacity of governments to function especially if local conditions prevent reforms from producing material differences in outcomes.

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