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Summers questions development policy research

What should development policy researchers and policymakers be thinking about today, and what should they be thinking about over the next few decades? Lawrence H. Summers shares his thoughts.

Summers, then deputy secretary of the U.S. Department of the Treasury and former chief economist of the World Bank, reviewed some of the pressing questions for development policy with participants of the eleventh Annual Bank Conference on Development Economics, held April 28­30 in Washington, D.C. The following article draws from his remarks.

Six questions for researchers and policymakers

When I try to reflect on what the world doesn't understand as well as it would like to, I am left with the feeling that we have a lot more thinking and institutional development to do. So, I would like to share six questions with you. I'll reflect a little bit on the answers, but much of my motivation is to stimulate thought.

1. How do we reconcile global integration with other crucial objectives?

As we look at the global economy and at national policy toward international economic issues, three imperatives seem clear.

We are for integration because of the benefits of freer trade, because of the benefits of fair investment, because of what integration means for links between states and reductions in the risks of conflict.

We are, in addition, for national sovereignty, the idea that we as Americans choose our taxes, choose our redistributive policies, choose our environmental standards—and similarly for the people of other nations. So the second imperative is sovereignty.

And a third imperative for most of us is the pursuit of public purposes that markets, left to their own devices, may not produce—the right opportunities for the poor, the right environmental policies, the kind of outcomes we want.

As we think about the development of our global economic institutions, it is these three things that need to be reconciled. For many people this is easy. For Milton Friedman, public purpose is a minimal objective. If we have integration and if we have sovereignty, then—because of the tremendous mobility of capital and businesses—it will prove difficult to impose redistributive tax rates and difficult to regulate in an effective way. And he sees that as an advantage rather than a disadvantage.

For Pat Buchanan and other isolationists, this is not a difficult problem. It is imperative to maintain national sovereignty. Public purpose in the form of appropriate regulation and taxation is essential. So, integration has to be sacrificed.

For global visionaries, this is not a hard problem. They suggest that just as federal regulation in the United States entered a whole set of areas that had traditionally been reserved to the states as interstate commerce increased, so too we need more regulation of questions about the flow of capital, questions about the level of taxes, questions about standards set at the international level. They rarely, as global visionaries, have to run for office in any of our countries.

And so if one adopts any two of these goals, solving the problem is quite easy. But it seems to me that for those who are thoughtful, the challenge really is to reconcile all three, and they can never be perfectly reconciled. Our challenge is to find the right ways to reconcile them. But if we try in our policy approaches, as we sometimes do, to elevate any one or even any two, we will go very much astray. And as we think about the development of the global trading system in particular, this is a special imperative.

2. What posture should countries take on global capital flows?

It is tempting to see the global capital market as imposing large costs on nations as capital moves in and out too quickly. Certainly, events give cause for concern in that direction.

I have been struck, though, as we have looked at the various crises, that in almost every case where those problems appear most central, policy created a substantial bias in favor of short-term capital flows, whether through the issuance of short-maturity debt with Mexican tesobonos, through tax breaks for short-term offshore bank deposits in Thailand, through the tailoring of financial instruments to be perfectly attuned to hedge fund preferences as with the Russian GKO treasury bills, through discriminatory capital controls that favor short-term capital and oppose long-term capital in the Republic of Korea.

There is also a kind of bias in favor of short-term capital created by the government provision of exchange rate guarantees whose duration can never be absolutely certain and which therefore encourage the inflow of short-term capital. And so it seems appropriate to frame the question of how we can encourage policy regimes that will not discourage short-term capital but will discourage the inappropriate encouragement of short-term capital that has led to such large problems.

There's a rich and varied debate, and the right answer will differ from situation to situation, as with Chilean-style controls. But in most of the cases that we look at countries are actually on the other side of it, creating a bias for short-term capital to save costs. How can they be encouraged to make better choices that recognize that short-term capital is also liquidity? It is sometimes the only kind you can get.

I don't think we have all the answers, and I think we will find that the question of exchange rate regimes will be particularly important in this regard—with an increasing conviction that the optimum may lie toward more flexible regimes or more heavily institutionalized pegged arrangements.

3. How can financial crises be resolved?

It has become clear that without policy change and without strong policies, crises are unlikely to be resolved in any country. Crises typically follow a period of very substantial capital outflow. And the provision of liquidity, without changing the conditions that led to the capital outflow, is likely to lead to the outflow of the liquidity, leaving only debt behind.

At the same time, it is very clear in each of the major episodes we have all studied that there came a moment when the investors' calculus shifted from the long-run fundamentals of the country—was policy sound?— to a comparison of the quantity of reserves available with the quantity of short-term debt coming due in the next few months. At that moment the situation worsened very dramatically and no longer became amenable to a simple fix through the restoration of policy to restore confidence.

We obviously want to find ways—and it goes back to short-term capital flows—of making it as unlikely as possible that countries will find themselves in such situations. But when they do, there are very difficult questions involving finding the right provision of public sector liquidity and private sector involvement.

Bagehot's use of the term "lender of last resort" suggested an early appreciation of the concept of dynamic consistency, and we do not as yet have a clear doctrine. Indeed, one of the doctrines in this area held by some is that it is a bad idea to have a clear doctrine— calculated ambiguity and all that—for the respective roles of the private and public sectors.

What is clear and now agreed is that this is an area where the answer cannot be extreme. Appropriately conditioned finance has and no doubt will have a constructive role to play in crisis resolution. A stable and healthy financial system cannot be based on the principle that in any and all situations those who extend credit will be repaid— certainly not when those who extend credit have been compensated with very substantial risk premia. And so a critical task before the international community will be to come to greater understandings. We believe that this is most appropriately done case by case because crises differ in how they will be resolved.

4. How do we best put into practice our shared sentiment that appropriate attention to the vulnerable is morally right, politically necessary, and internationally prudent in time of crisis?

It is easy to enunciate that as a convincing proposition. But it seems the questions that need to be reflected on in putting into practice that sentiment—which I haven't seen reflected on as fully as they might be—include the following.

First, is this a call for more and larger deficits to support more social spending systematically in time of crisis? Or is it a call for different budget priorities? If it is a call for different budget priorities, what spending that is currently maintained is thought to be unwisely maintained in crisis and should be systematically reduced?

Second, how does one square the critique that it is important to focus conditionality as much as possible to avoid resentment from host-country governments with the critique that it is necessary to have a far-reaching investigation of spending priorities?

Third, how does one confront the issue of fungibility in providing support? Is the appropriate approach to support laudable social objectives and leave the rest to take care of itself? Or is the right approach to condition that support on some broadly appropriate reformulation of public expenditure priorities?

Fourth, how does one square the imperatives of crisis resolution with long-standing social imperatives? Although I am no expert on the question, it is my impression that the poorest and most vulnerable in any society are usually also the most voiceless—and not the most likely to upset political and social stability in time of crisis.

To what extent is a crisis, therefore, a time when assistance should be focused on them because they are most vulnerable? And to what extent is a crisis a time when the focus of policy should be on those whose lives have been most disrupted by the crisis, even if they are not objectively the poorest?

This list of questions could be continued, but it seems to me that it is high time for the international community to move beyond what surely are appropriate sentiments, and in many cases significant actions, to think through a little more carefully what our doctrines and approaches should be in this area.

5. How can we in the international community substitute or best produce the social capital that is ultimately important for continuing a successful economy?

I don't think anybody completely understands—certainly I don't—the problems of states of the former Soviet Union, or the problems of Indonesia, or the problems in many African countries. And the problems obviously differ in very profound ways. But as I reflect on them, I am convinced that there is a common element of a lack of social connection—a lack of links between people because governments have preempted not just all the political and economic space, but also much of the social space. These are low-trust societies—societies in which the basis for the most rudimentary enforcement of law is often lacking.

It is much easier, it seems to me, to frame the problem than to solve it. Without secure property rights, there will not be commerce. Contract enforcement is crucial to business—to business connections. It is much easier to frame the problem than to know what the international community can do about it—to produce tangible results very quickly. It is perhaps inevitable that support efforts focus on problems that can be solved—whether those problems are macroeconomic stabilization or the eradication of particular diseases. But that doesn't mean that the lack of effective institutions is not at the center of the problem.

Whether the right approach is to work to develop stronger institutions or to work around the lack of effective institutions, it seems to me that we don't know the answer. But here, too, if we're going to make our efforts as effective as we can, it is appropriate to reflect on this rather carefully.

6. How will our thinking differ 30 years from now?

I am no expert on the history of economic thought, but I have been struck that discredited doctrines are less stupid than ideas that fit one time and not a subsequent time. I am told by those who are knowledgeable about Malthus's theory that it was actually a rather accurate description of the dynamics of population and food supply in the several hundred years that preceded his enunciating it. It was not the obvious fallacy that it is held to be in today's elementary economics textbooks.

It is not difficult to understand, studying the history of the 1930s, why the economists of the 1940s and 1950s developed a set of doctrines that were heavily centered on the achievement of more aggregate demand as the central objective of economic policy.

It is not difficult to understand—looking at the manifest failure of the American and British economies during the 1930s and their tremendous success in the Second World War, and looking at the success of the Latin American economies during the 1940s when they were cut off from international trade—why a rather dirigiste economic doctrine came to be established after the Second World War. And it is not hard to understand, looking at the experiences of the last 25 years, why the right doctrine for this time emphasizes markets, emphasizes openness, emphasizes the benefits of competition.

But history should remind us —just as the World Bank's celebrated 1979 report on the Romanian economic miracle should remind us: is there some profoundly different change in process that leads one to think that nothing is being produced today that will look as foolish 20 years from now as the Romanian economic miracle report of 1979? I doubt it.

As we think this through, we have no alternative as policymakers but to operate within our best guesses and our most accurate judgments about how the world works today. But particularly for those of you who focus on research, it seems to me appropriate to reflect on the fact that there will probably be some quite substantial changes in doctrine over the next 30 years. There certainly have been over most 30-year periods in the past.

That is why it is important to anticipate what those changes will be. If one thinks about most past changes in doctrine—whether it's away from the hard-core Keynesian policies, whether it's away from the more dirigiste orientation—if they had come somewhat sooner rather than somewhat later, most of us would judge that the world would be a better place. So we need to apply that same kind of rigorous scrutiny to what we hold as conventional wisdom today.

Lawrence Summers was appointed secretary of the U.S. Department of the Treasury in July 1999.

Other participants in the eleventh Annual Bank Conference on Development Economics delivered papers on topics ranging from economic architecture to the economics of transition to social exclusion and crime and violence. Copies of their papers can be downloaded from www.worldbank.org/abcde.