A plague of finance
Sep 27th 2001
From The Economist
print edition
Anti-globalists see the “Washington consensus”
as a conspiracy to enrich bankers. They are not entirely wrong
WHEN
they criticise globalisation, sceptics are not just talking about economic
integration across borders, or about the particular economic policies, such as
liberal rules on trade and international investment, that directly facilitate
it. They have in mind a much larger set of economic nostrums and institutions:
the policies of the “Washington consensus”, as it is known, and the
international bodies, notably the International Monetary Fund and the World
Bank, that strive to put it into effect.
The term
“Washington consensus” was coined by the economist John Williamson in 1989. He
called it that because of the support it enjoyed from the American government
and (not coincidentally) from the Fund and the Bank, the big Washington-based
institutions. He said it stood for ten policies. Measures to promote trade and FDI were high on the list, but the new orthodoxy, as he
described it, also ran to the following: fiscal discipline (ie, smaller budget
deficits), fewer subsidies, tax reform, liberalised financial systems,
competitive exchange rates, privatisation, deregulation and measures to secure
property rights.
In the
view of many sceptics, this broad “neo-liberal” agenda has been deliberately
designed to serve the needs of the rich at the expense of the poor. The
sceptics' thinking on trade and foreign investment has already been discussed;
their view of the rest of the formula is just as scathing. Fiscal discipline,
curbs on subsidies and increases in taxes—measures long emphasised by the IMF in its dealings with distressed developing-country
borrowers—directly hurt the poor, they say. Privatisation, financial
liberalisation and industrial deregulation work to the same effect, by
delivering windfall profits to domestic and foreign speculators, by stripping
the state of its assets and by weakening rules that protect consumers and
workers from abuse.
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These
policies are forced on poor-country governments regardless of their own views
and priorities, incidentally undermining democracy in the third world. In the
longer term, this kind of development—in effect, on terms dictated by the rich
countries—saddles the developing countries with crippling debts. It also
exposes them to the crazy fluctuations of the global business cycle. East Asia,
one-time exemplar of the Washington model, discovered that to its cost; now
Argentina, another darling of the Washington development establishment, is on
the rack for the same reason. Insupportable debts and chronic instability
worsen the developing countries' dependence on aid, and allow the IMF to tighten the screws even more vigorously next time,
at the direction of American bankers. In every way, sceptics believe, the
Washington consensus is a calculated assault on the weak.
Extreme
as this caricature may be when taken as a whole, it contains some truths—which
is why, for all its absurdity, it is recognisable. The idea that the Washington
establishment is engaged in a deliberate conspiracy to oppress the third world
may be nonsense, but there have been mistakes, big and small, and unintended
consequences aplenty. The problem is that the valid criticisms are buried under
a heap of error, muddle and deliberate distortion. The IMF,
the Bank and America's Treasury Department would all feel much more threatened
if the shards of intelligent criticism could be filtered from all the rubbish
and gathered together.
Beware foreign capital
One of
the clearest lessons for international economics in the past few decades, with
many a reminder in the past few years, has been that foreign capital is a mixed
blessing. This stricture does not apply so much to FDI because,
unlike debt, FDI does not need to be serviced and
cannot flee at short notice. As a result, providers of FDI
themselves bear most of the financial risk attached to the investment, but this
advantage comes at a price. Over the long term, FDI
is a more expensive form of finance than debt because the outflow of remitted
profits usually gives this kind of investor a bigger return than a foreign bank
or bondholder could expect to receive. All the same, FDI
is not only less risky for the host country, it is also more productive, as
noted earlier, because of the technology and techniques that come with it. It
is expensive from the host country's point of view, but good value.
Other
forms of foreign capital, and especially short-term bank debt, have led many a
developing country into desperate trouble. Because of the debt crisis, the
1980s were a lost decade for Latin America; today, in different ways, Argentina
and Brazil are both in difficulty again because of debt. The financial crisis
of the late 1990s set back even the East Asians, up to then the best-performing
of all the developing countries. Why has this happened—and why so often?
Borrowers,
obviously, have to take their share of the blame for borrowing too much, though
that is rarely the whole explanation. Governments that borrow heavily in order
to finance recklessly large budget deficits are plainly at fault. There was a
lot of that in the 1970s and early 1980s. The case of corporate borrowers in
developing countries is more complicated. They may sometimes borrow amounts
which seem individually prudent given certain macroeconomic assumptions—such as
no devaluation of the currency—but which become collectively insupportable if
those assumptions turn out to be wrong. This happened in East Asia in the
1990s, with the further complication that much of the borrowing was channelled
through domestic banks, meaning that the ultimate borrowers were unaware of the
system-wide exchange-rate risk.
Sometimes,
therefore, developing-country banks have been at fault as well—and their
governments too, for failing to regulate them effectively. Some governments
have also allowed, or actively encouraged, too much foreign borrowing by firms,
with or without the intermediation of domestic banks and other financial
institutions. Even some governments that have taken care to keep their own
borrowing in check have been guilty of these failures of regulation and
oversight.
But at
least as much of the blame for the developing world's recurring debt traumas
lies with rich-country lenders and, at one remove, rich-country governments.
Modern banking operates, notoriously, under the persistent influence of moral
hazard. This arises because deposit-taking banks are intrinsically fragile
operations—and because governments are reluctant to let them fail. Banks are
fragile because they promise depositors to repay deposits on demand and in
full, even though they are unable to keep that promise if a significant number
of depositors decide to exercise their right all at once. To avoid the risk of
bank runs, which is high given the design of the contract with depositors,
governments arrange deposit-insurance schemes, and other forms of assurance,
including the doctrine of “too big to fail”.
There
are good reasons for this. If a bank fails, it may take other banks and
enterprises, not to mention depositors' savings, with it; the broader payments
system may also be imperilled. Historically, bank failures are associated with
economy-wide recessions; for example, they helped to bring on the Depression of
the 1930s (which was the inspiration for the modern deposit-insurance model).
But the upshot is that banks are systematically protected from the consequences
of their reckless behaviour.
Modern
banks keep a far smaller fraction of their deposits as reserves than their
historical forebears. Depositors have no incentive to supervise the banks by
keeping an eye on reserves or by withdrawing money from the ones that are
taking too many risks: their deposits are protected in any case. And banks have
a correspondingly big incentive to compete aggressively for deposits which they
can lend at high interest rates to risky projects. It is a formula for
ruin—and, despite the efforts of regulators to measure and curb those risks, it
keeps on working exactly as you would expect. In almost every case of
spectacular boom and bust in recent years, in rich and poor countries alike, an
exaggerated cycle of banking greed and fear has been a principal cause.
Too big to fail
So when
sceptics accuse rich-country governments of being mainly concerned with bailing
out western banks when financial crisis strikes in the third world, they have a
point. The pernicious logic of “too big to fail” applies in the international
context as well as the domestic one. If you are going to go bust, make sure you
are a big developing country rather than a small one, with debts large enough
to threaten catastrophic damage to America's financial system. That way you can
be assured of prompt attention.
Until
the intractable dilemmas of global bank regulation have been resolved—supposing
they ever can be—the hazards of borrowing from abroad do argue for greater
caution than poor-country borrowers have often used, or been advised to use by
the IMF and the World Bank. The confidence with which the Fund
and the Bank advised, or required, countries to abolish capital controls now
looks misplaced in many cases.
The
policy was doubtless well-intended. There is no question that moderate inflows
of debt can speed development. This is why a good credit standing is a valuable
asset for a developing country, and why too ready a willingness to default on
debt usually proves self-defeating. But if bank regulation in rich countries
leaves much to be desired, in many poor countries it is even worse. No doubt it
would be best to bring financial regulation in developing countries up to the
standard, such as it is, of regulation in America and Europe. But that is
easier said than done. In the meantime, taxes or controls on short-term
foreign-currency inflows, of the kind Chile has used with success, may well be
better for some poor countries than the alternatives of, on the one hand, no
inflows at all and, on the other, completely unrestricted inflows intermediated
by a weakly or corruptly regulated domestic financial system.
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In many
other respects, however, the sceptics' attacks on the Fund and the Bank are
ill-conceived. The IMF, especially, is criticised for
sending its experts into developing countries and commanding governments to
balance the budget in ways that assault the poor—by cutting spending on vital
social services, ending subsidies or raising taxes on food and fuel, levying
charges for use of water, and so on down the list of shame.
Measures
to curb budget deficits are often unavoidable by the time the Fund is called
in. The only way to reduce a budget deficit is to raise taxes or cut public
spending. In many developing countries, where tax systems are narrowly based
and unsophisticated, governments may have few options in deciding how to go
about it. It would not be in the political interests of the Fund or the Bank to
recommend measures that fall heavily on the poor if there were an obvious
alternative.
However,
the Fund, especially, may have invited much of the criticism it receives in
this respect because it specifies policy changes in such detail. The IMF should strenuously avoid letting itself be seen as
running the country, giving the government instructions and telling workers and
voters to get lost. On the other hand, many sceptics seem to be under the
impression that all was well in the countries concerned until the Fund barged
in. The Fund turns up only when things have already gone very wrong indeed—and
only when the government in question has asked for its help. That last point is
surely worthy of more attention than the sceptics pay to it. If governments
find the Fund's conditions so oppressive, they always have the option of refraining
from asking for its help.
Governments
know that the alternative to the Fund's intervention would usually be an even
sharper contraction of public spending (including on social services) and/or an
increase in taxes (including on things the poor need to buy). By the time the IMF is called in, the question whether to curb government
borrowing is not so much a matter of weighing, as sceptics suppose, the case
for laisser faire against the demands of social justice. Often, in the
good-faith judgment of the IMF's officials, it is just an
inescapable necessity if the economy is to be stabilised. And at times of
impending economic collapse, stabilisation is very much in the interests of the
poor, who suffer most during slumps.
In
fact, most of the policies of the Washington consensus serve, or are capable of
serving, the interests of the poor directly, not merely by promoting growth. If
governments have been at fault in defending that agenda, it has mainly been in
failing to emphasise this. The centrepiece of these policies, fiscal
discipline, is sometimes necessary to avert an economic calamity; but even in
more normal times, the alternative to steady control of government borrowing is
usually high inflation. That, all the evidence shows, hurts the poor more than
anyone else.
As
noted by Mr Williamson back in 1989, the consensus called not just for fewer
subsidies, but for new priorities in public spending, especially more effective
support for industry and more spending on education and health—priorities intended
to help the poor which the Bank has tried hard to put into practice. The need
to broaden the tax base, so as to support additional public spending without
destabilising the economy, is another idea that favours the poor, because there
is no other way to provide the resources necessary to pay for effective safety
nets. Deregulation and improved property rights can also make a real difference
to the poor. As the work of Hernando de Soto has shown, it is the poor who
suffer most from obstacles to small-scale enterprise and insecure titles to
land.
Many
sceptics might warm to the Fund and the Bank if they paid more attention to the
criticisms directed at the two institutions from the political right.
Conservatives worry not so much because the Fund is too mean, or the Bank too
keen on market economics, but rather the opposite: they complain that both are
engaged in throwing good money after bad. Worse than that, critics on the right
argue, the two institutions reward the bad policies that got the patients into
trouble in the first place, thereby creating their own kind of moral hazard.
If the
Fund and the Bank were simply shut down, as many sceptics and many
conservatives would wish, the flow of resources to the developing countries
would certainly diminish, at least in the short term. The world economy would
be a harsher place for the poor countries. The conservatives argue, in effect,
that this would be good for them in the longer term. Those sceptics who favour
slower economic growth for the third world would also be gratified, presumably,
if the Fund and the Bank packed up. But it is hard to see what those who are
not opposed to development as such see in this course.
Trying to get it right
The IMF and the Bank have certainly made mistakes. They have
had spells of over-confidence, though they cannot be accused of that at the
moment. Noted scholars such as Joseph Stiglitz, a former chief economist at the
World Bank, have criticised them for technical incompetence, and for
theological devotion to discredited economic theories; but other economists
have argued in their defence, saying, plausibly, that they have done their best
in difficult circumstances. They have certainly neglected the importance of
allowing governments to “own”, and take responsibility for, their policies—a
mistake which supplicant governments, anxious to deny responsibility, have
usually been keen to encourage. But the Fund and the Bank are aware of this
criticism, and are trying to do something about it.
Other
improvements in the way the international financial institutions work are
surely called for. Many different panels of experts have produced countless
proposals, big and small, and some of these are being taken up. Overall, a
shift of emphasis is needed. Now that many developing countries have access,
for good or ill, to the global capital markets, the Bank needs to focus on
disseminating knowledge rather than money. And for both political and economic
reasons it would be better if the Fund, for its part, specialised in providing
liquidity during emergencies, rather than development finance, subject to
simple financial conditions rather than immensely detailed policy blueprints.
The
institutions themselves have gone far to acknowledge their mistakes, and the
need for reform. In view of this, the ability of the sceptics to maintain their
hysterical animosity toward the institutions is surprising. In its way, it
demands a measure of respect.