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Fatal consensus


01/2005 		 

Fatal consensus

For a long time, only economic policies along the lines of the Washington Consensus were considered viable. This went on for too long. In many countries, the doctrine did not lead to growth but caused financial crises, greater indebtedness and even more poverty. The Washington Consensus has certain macro-economic weaknesses, which make it unsuitable as a development policy. An alternative approach is necessary.


[ By Jan Priewe ]

John Williamson, an economist at the Institute for International Economics in Washington, coined the expression “Washington Consensus” fifteen years ago. In ten points, he summarised his understanding of economic beliefs shared by the World Bank, the International Monetary Fund (IMF), the US Treasury and the Department of State in respect to Latin America (see Box 1). Before long, the Consensus came to be viewed as a general economic model for all countries and, above all, as a strategy for developing and for transition countries.


Box 1: John Williamson’s 1989
“Washington Consensus”

1. Reduction of budget deficits to a non-inflationary level
2. Redirection of public expenditure to areas such as education, infrastructure et cetera
3. Tax reforms to lower marginal rates and broaden the tax base
4. Transition to market-determined interest rates (financial liberalisation)
5. Sufficiently competitive exchange rates which induce a rapid growth in non-traditional exports
6. External trade: Removal of quantitative trade restrictions; tariff reductions
7. Abolition of barriers to foreign direct investment
8. Privatisation of state-owned enterprises
9. Deregulation for “start-ups”, general abolition of restraints on competition
10. Better protection of property rights, particularly in the informal sector


According to Williamson, the Consensus was never based on pure neo-liberalism nor was it supposed to be an attempt to minimise the role of the state. Nonetheless, the term Washington Consensus was frequently understood in this way. Williamson, who has been involved in Washington-based debate for years, says the Consensus survived until the mid-1990s. Then, the powerful US Treasury began to express other views on various issues, for instance, by advocating more restrictive fiscal policies, rapid liberalisation of cross-border capital transactions and either entirely fixed or completely floating exchange rates (“corner solutions”). Later, the Bush administration similarly shied away from the Washington Consensus.

Some of the general criticism was reflected in an “Augmented Washington Consensus” proposed by Dani Rodrik, an economics professor at Harvard University (see Box 2). Rodrik added ten more points to the original ten “Commandments”. The most important concerned the establishment of institutions supporting the market and poverty alleviation. Joseph Stiglitz, in particular, had criticised the original Consensus because its rules were applied uniformly to all countries, without taking into account any locally specific aspects. At an InWEnt-conference in Berlin in September 2004, Williamson himself admitted that he now appreciates a more active role of the state, which would go beyond the establishment of institutions and the fight against poverty. Williamson also called for an countercyclical fiscal policy, careful liberalisation of capital transactions and closer observance of the proper sequencing of reforms.


Box 2: Dani Rodrik’s 2003
“Augmented” Washington Consensus

11. Improvement of “corporate governance”
12. Curbing corruption
13. Flexible labour markets
14. Adherence to WTO rules
15. Adherence to international standards in the financial sector
16. “Prudent” liberalisation of cross-border capital transactions
17. Fixed or floating exchange rates
18. Independent central banks/inflation targeting
19. Social safety nets
20. Poverty reduction

In practice and irrespective of Williamson’s or Rodrik’s lists, the Washington Consensus looks something like this: macroeconomic decision making (on monetary, fiscal and exchange rate policies) must ensure adequate price stability, which is usually defined as single-digit inflation. To achieve this goal, restrictive monetary and fiscal policies are crucial. On top of this, flexible exchange rates are normally promoted. Fixed, inflexible exchange rates remain the exception.


Aid as compensation

Most developing countries liberalised their financial sectors and cross-border capital transactions in one go. As a consequence, net capital inflows occured and the countries accepted high and sustained current account payment deficits. In low income countries (up to $ 755 per capita per annum), politically conditioned loans by multilateral financial institutions were meant to close the financing gaps. In emerging economies with higher per capita income, private capital inflows were expected to cover the deficits. In both cases, however, we are dealing with debt strategies in a wider sense, which follow the tradition of old development theories assuming that, essentially, underdevelopment stems from a lack of domestic savings and capital and the resulting “shallow” national capital markets.

Overall, only a passive role is seen for macroeconomic policy making in setting the conditions for stabilisation. Economic dynamism and growth are expected to derive from structural adjustment, in other words, from privatisation, deregulation, the creation of flexible labour markets, free trade, and stronger market-led prices as well as through investment in infrastructure and education. Neither an expansionary macro-economic policy meant to stimulate economic growth, nor the regulation of cross-border capital transactions match this model of thought.

The promoted strategy has indeed led to much lower inflation rates in developing countries over the last two decades. However, it has not triggered more growth. In the 1990s, the economies of low-income countries only expanded by an average of 1.4 percent per capita annually. In Sub-Saharan Africa, the economy shrank by 0.2 percent annually (non-weighted mean values on overall broad spread). Data were only slightly better for middle-income countries. However, without higher growth, poverty reduction is doomed to fail and the Millennium Development Goals will not be achieved. While it is true that the reforms did lead to improved market efficiency in many countries, the high interest rates proved an obstacle to capital investment, and the limited availability of loans for investment impeded growth. Moreover, restrictive monetary policy is too often used to counteract impending outflows of capital and exchange rate depreciation. As a result, national capital markets cannot develop.


Six weaknesses

All summed up, a policy along the lines of the Washington Consensus does not lead to the growth hoped for. Many countries, which followed the model closely, have failed (for instance Argentina) or depend heavily on transfer payments (Uganda). However, other countries, which deviated considerably from the Consensus, or interpreted it less strictly by opting for long-term incremental reforms, achieved great growth. This was particularly so in the case of China, but also in that of other Asian countries. The Washington Consensus paradigm is obviously so blurred and incomplete that it may lead to disastrous consequences as well as to spectacular success. Six macroeconomic weaknesses of the doctrine are at the root of failures.

1. Anti-inflationary policy. For many developing countries, single-figure inflation rates are already an enormous step forward. This goal is difficult to achieve under the conditions of largely free international capital movements. There is a hierarchy of currencies on the world financial markets and it also applies to foreign exchange. This hierarchy is led by the US Dollar and the Euro. Weak currencies have the stigma of a particular risk. To some extent, they suffer from a competitive disadvantage leading to depreciation risks, outflows of capital and domestic flight into hard currencies (dollarisation). The benchmark for weak currencies, under global financial market conditions, is low inflation in hard currency countries. Stricter goals in anti-inflationary policy are therefore necessary. Any country that cannot keep up, and cannot or does not want to implement effective capital controls, is heading for serious problems. Under these conditions, a national banking sector with a broad outreach and increasing depth is unlikely to develop in the service of the population at large. Consequently, affected countries depend even more on external funds, thus burdening their balance of payments even further.

The traditional instrument to fight inflation is restrictive monetary policy, often in the form of money supply control combined with restrictive fiscal policy. This can lead to prohibitively high interest rates, if other important causes of inflation, particularly expectations of currency depreciation, are not controlled. Most developing economies are small and open. Typically, their import levels are high. Therefore, each devaluation implies rising costs, and it is usually hard to avoid consequent wage and price increases. Where exchange rates are not stable, restrictive monetary and fiscal policy must be heavily applied to stem inflation – the snag being that they stifle economic growth at the same time.

2. Flexible exchange rates? Completely free exchange rates usually fluctuate widely, often with a trend towards devaluation. But each instance of devaluation increases the inflationary pressure as well as the real burden of foreign indebtedness, which is denominated in hard currency and must be repaid in that currency. On the other hand, finance for debt service is usually obtained in local currency, which has lost value (currency mismatch). Even in the case of extremely favourable loans, devaluation has a tendency of increasing foreign indebtedness. If a country prevents devaluation by high interest or by interventions on the foreign exchange market, it risks its own currency becoming overvalued thus damaging its competitiveness. Fixed exchange rates have many advantages, but they require mechanisms to prop them up. These include successfully combating the home-made causes of inflation, and ensuring that the balance of payments does not show any excessive deficits. Exchange rates, which fluctuate, but are contained within a particular band, seem more appropriate than either fixed or fully floating exchange rates. Similarly, exchange rates, which are flexible in principle, but rather stable in practice, can make sense (managed floating).

3. Opening borders for all capital flows? Before the Washington Consensus, the governments of most developing countries exercised controls on the flow of capital, as the industrial nations had done before them. In many countries, controls were abolished in the hope for inflows of private capital from rich nations. Instead, this policy actually led to considerable outflows of capital from developing countries thereby weakening domestic financial systems. Inflows, on the other hand, tend to increase the debt burden. An issue of high relevance, moreover, is that the liberalisation of capital transactions is related to strong interest rate fluctuations. Reasonably stable exchange rates are not compatible with free capital transactions. Finally, monetary policy in open capital markets must adapt to the key interest rates in the hard currency countries (and include a country-specific risk premium). Monetary policy cannot simply be adjusted according to national needs.

4. Accepting a loss of equilibrium in the balance of payments. The Washington Consensus does not deal with current account deficits and foreign debts, even though both rank high among the key worries for most developing countries. John Williamson included them by stealth in his demand for “competitive exchange rates”. This term refers to excessive deficits in the balance of payments, which, according to the Consensus, should be avoided. However, it remains a controversial issue among academics as well as practioners what “excessive” means precisely. One thing is certain: risks related to balance of payment deficits are being understated. They concern indebtedness and exchange rate fluctuations. We must also take into account that the financial community itself or, in the words of Jagdish Bhagwati, the “Wall Street complex”, demands the option of short-term financial assets with higher rates of return and higher risks in emerging economies.

5. Tolerance of dollarisation. Dollarisation is a hot topic, particularly in Latin America. Only a few countries, mostly very small ones, have officially replaced their local currency with a hard foreign currency. But unofficial parallel currencies are known in many countries. Neither the original nor the augmented Washington Consensus addresses this issue at all. The Washington institutions and many governments have tolerated dollarisation completely underestimating the extent of the problem. Dollarisation makes local currencies even weaker and national financial systems more fragile. It also makes inflation and devaluation more likely and tends to trigger even more restrictive monetary policies. However, it is admittedly difficult to fight dollarisation, once it has gained ground.

6. Neglect of the local financial sector. There is no dispute today that national finance institutions, particularly banks, are strategically important for corporate financing, investments and economic growth. Nevertheless, the performance of banking sectors is alarmingly poor in most developing countries. Typical symptoms are high real interest rates, a lack of long-term loans and of access to bond and share markets. The Washington Consensus preaches the liberalisation of interest rate formation, which usually involves rising interest rates. The solution, according to the doctrine, is to open capital markets and to access foreign funds, particularly by tapping the sophisticated international financial markets. However, many Asian developing countries, not to mention China, demonstrate that local financial markets can probably offer sufficient funds with low inflation. State-run development banks and regulated credit markets often do play an important role – a clear breach of the Washington rules, and one, which Joseph Stiglitz in particular has denounced.


Conclusion

From a macro-economic view, let alone other criteria, the application of the Washington Consensus is highly questionable. A new model is needed, which reduces the risk of indebtedness and financial crises, fosters national financial systems with low inflation and makes higher economic growth possible, irrespective of the economic situation in rich nations. Of course, the “Ten Commandments” from Washington are not all wrong, but as a package they lead to a dead end.






Prof. Dr. Jan Priewe
teaches economics at the University of Applied Sciences in Berlin.
priewe@fhtw-berlin.de