April–June 1998
Volume 9, Number 2Opening the Door to New Ideas
How can empirical research and the exchange of knowledge help developing countries meet the challenges of globalization?
That was the question presented to participants at the tenth Annual World Bank Conference on Development Economics, held April 20–21 in Washington, D.C. "The conference," World Bank Chief Economist Joseph E. Stiglitz remarked in his opening address, "is dedicated to the principle that economic science—and the promotion of research, dissemination, and dialogue on economics—can improve the chances for growth and the alleviation of poverty in the developing countries of the world." The conference brought together some of the world’s leading scholars and practitioners in development economics to discuss a range of emerging topics, with a focus on four areas of inquiry—the effects and sequencing of financial market liberalization, the role of competition and regulation, ethnic diversity, and the role of geography in economic development (box 1).
A thematic link between these topics is the role of knowledge and scientific methodology in economic analysis and development. In his opening remarks Stiglitz emphasized the Bank’s need for new models and instruments to pursue a broader agenda than in the past. Beyond merely increasing GDP, the Bank is fundamentally concerned with improving living standards and setting a course for development that is egalitarian, democratic, and sustainable.
To achieve these goals, many shibboleths of development economics must be reassessed—for example, what might be called "the neoliberal model" of development. This model, said Stiglitz, "accords the government a minimal role, essentially one of ensuring macroeconomic stability, with an emphasis on price stability, while getting out of the way to allow trade liberalization, privatization, and getting the prices right." Many of these policies are necessary for economic success, but they are far from sufficient—and some may not even be necessary conditions. Some countries that have followed the dictates of the neoliberal model are still waiting for growth to improve, while others that have ignored them (or at least the recommended policy sequence) have experienced some of the highest rates of sustained growth ever recorded.
Stiglitz pointed out that the gap between neoliberal policy ideas (which often come close to ideologies in their absoluteness) and actual experience is evident in most of the "successful" reformers of Eastern Europe, countries that pursued privatization early but without complementary reforms to foster competition. These countries saw their GDP fall or, at best, stay the same. By contrast, China, which deferred privatization but encouraged competition, was rewarded with GDP growth so rapid that if the country’s provinces were separate countries, they would rank as the 20 fastest growing economies in the world of the past two decades.
The gap between prevailing ideas and actual experience also is evident in the financial crisis in East Asia, said Stiglitz. The crisis has been explained as a result of excessive government intervention by those who believe that government should play a smaller role in the economy. But some of those same critics were claiming not long ago that the remarkable growth of these economies was at least partly attributable to the fact that government did not intervene. On the subject of East Asia, Stiglitz pointed out, systematic analyses consistent with empirical evidence "are in short supply," especially with regard to the effect of high interest rates during a financial crisis.
Because the links between diagnosis and policy are so close, argued Stiglitz, we must be especially careful "not to confuse ideology with economic science." What is needed is a scientific approach to development that separates solid research from economic journalism. By rigorously testing assumptions and theories against empirical evidence, the scientific method strengthens our understanding of development through constant revision.
What does an examination of recent economic trends suggest the focus of policy analysis will be in coming years? That question was taken up by Stanley Fischer, First Deputy Managing Director of the International Monetary Fund (IMF) and the founder of the conference series in 1989, when he was the Bank’s Chief Economist. In the tenth anniversary address Fischer first reflected on the development consensus at the beginning of the decade. The Bank’s World Development Report 1991, representative of the consensus at least within that institution, emphasized investing in people, improving the climate for enterprise, opening economies to trade and investment, getting macroeconomic policy right, and having governments do less where markets worked, or could be made to work, reasonably well. The lessons of the transition process and the recent financial crises would not change the basic message much, he said. But some issues would receive more emphasis, such as efficient regulation, institutional development, governance, the environment, urbanization, and income distribution.
Globalization, however, could produce major changes in the message, Fischer said. Most countries will liberalize their capital markets, but the process should be gradual, occurring "only as the domestic financial system is strengthened and prudential and other controls are in place." Dealing with the risks posed by the globalization of capital markets will focus increasing attention on developing and implementing agreed on standards, such as on banking system behavior and supervision. Also at the fore, Fischer predicted, would again be "the question of the optimal exchange arrangement and of the desirability of maintaining a national money." As globalization continues to bring profound changes, actions on a broad front will be required in most developing economies, and even some advanced economies will need to improve institutions and policies to meet international standards.
New models and new perspectives
The need for new models and deep, empirically grounded analysis was a theme running through many of the papers presented at the conference. Bruce Greenwald agreed with Stiglitz that traditional open economy models, which assume perfect information, offer little insight into the functioning of financial markets at a time of crisis. Greenwald pointed out that the limitation of these models is particularly evident in the cases of Mexico and East Asia, where they were of little help in identifying the root causes of the crises, measures for alleviating them, or ways to prevent such crises from recurring. Greenwald proposed an alternative model based on the assumption of imperfect information.
Asl1 Demirgüç-Kunt and Enrica Detragiache discussed the popular view that financial liberalization increases the likelihood of a crisis. Basing their conclusions on a detailed analysis of a large body of data, they emphasized the importance of strong institutions to offset the dangers that financial liberalization can pose. Their findings strongly suggest that institutional development and the regulatory framework needed for financial markets to operate efficiently should be emphasized early in the liberalization process.
The need for strong institutions was affirmed by Paul Joskow, who looked at efforts to reform infrastructure sectors in developing countries. Although privatization is "a centerpiece of the modern ideology of reform," in Stiglitz’s words, Joskow’s findings reinforce the view that privatization without strong regulatory institutions can be counterproductive for economic performance. Reconsidering another truism of the modern ideology of reform, the need for competition, Jean-Jacques Laffont examined the potentially devastating results of unleashing competition in a weak institutional setting.
New approaches were also in evidence in papers on ethnic conflict and on the role of geography in economic growth. While previous work has claimed that ethnic diversity harms growth, Paul Collier found that the relationship depends on the political system: in democracies ethnic diversity is a strength, but combined with autocracy it is particularly detrimental to economic performance. Donald Horowitz advanced a theory of ethnicity that accounts for the tendency of political leaders to mobilize along ethnic lines and work against "maximal inclusiveness," even in democratic societies.
Paul Krugman discussed geographically based models that account for the division of the world into industrial and nonindustrial countries, the emergence of regional inequality within developing countries, and the growth of giant urban centers. Krugman argued that natural features matter mainly insofar as they act as seeds around which cumulative processes crystallize—suggesting that while geography may have been destiny in the past, it need not be so in the future.
Taking the opposite tack, John Luke Gallup and Jeffrey Sachs emphasized the importance of geography for both macroeconomic growth and policy choices. Asking difficult questions about the failure of tropical regions to thrive and today’s high rate of population growth in countries least equipped for rapid development, they echoed Stiglitz’s call for development assistance to focus on transmitting good policies. Gallup and Sachs urged policymakers to "reexamine the balance of aid between policy-based lending to individual governments, which is the current popular form of aid, and greatly enhanced aid for basic science on tropical agriculture and tropic public health." In particular, they said, "perhaps a more effective approach to malaria would do more to improve the economic environment—and incidentally, improve policy—by improving the incentives for good policies that face the sovereign."
Lessons in financial market liberalization
With the recent events in East Asia uppermost in most minds, conference participants agreed that the need for deeper policy analysis is particularly acute for financial markets. Nobel prize winner James Tobin, in the keynote address, spoke about the implications of financial market globalization for national currencies. Liberalization and deregulation of international financial transactions have aided economic progress in developing countries, he conceded. But these trends also undermine the monetary sovereignty of developing economies, particularly those committed to a fixed exchange rate. "When private banks and businesses can borrow in whatever amounts, maturities, and currencies they choose, they create future claims on their country’s reserves," he said. As a result governments and central banks may be forced to adopt monetary and fiscal policies that sacrifice growth to protect reserves. Thus some friction in international financial institutions and markets should be retained.
To support independent currencies and modern financial systems, developing countries need to build or strengthen institutions of financial reform and regulation. U.S. experience in regulating financial institutions and markets is worth drawing on, for both its positive and its negative lessons. Further liberalization of cross-border transactions was among the conditions for bailout packages for Asian economies, despite the evident need, Tobin argued, for more regulation of banking and financial institutions in some respects. Even some critics of the bailout insist that "if governments and international agencies would just get out of the way, free markets would reach ideal solutions." But Tobin urged caution in applying "Invisible Hand propositions" to financial markets, particularly international ones. These propositions, he pointed out, apply to a single closed real economy, with no money.
Until recently the virtues of financial market liberalization went largely unquestioned. The basic tenet of reform was that, as Stiglitz put it, "free and competitive markets are the basis of a capitalist economy and have delivered enormous fruits to those that have adopted them." But the crisis in East Asia has shown that "there are important differences between financial markets and other markets, differences that suggest that although there is a presumption that trade liberalization is welfare-enhancing, liberalization of financial markets may well not be." As the "brain of the economy," said Stiglitz, successful financial markets will promote growth if they have sturdy institutions to help them do their work, including strong government regulation, effective laws, and vigilant enforcement.
The perils of information imperfections for financial market actors were explored in detail by Bruce Greenwald. The sudden crises in Asia and Mexico, said Greenwald, revealed the shortcomings of traditional open economy models, which assume efficient global financial markets. But because global financial and product markets tend to mitigate rather than intensify these local economic disturbances, market imperfections must be at work. Looking at one broad form of financial market imperfection—the information asymmetry between local firms and bank management, which are usually well informed about a firm’s prospects, and outside investors, which may not be—Greenwald showed that imperfect information can severely restrict financial market transactions. Amplifying rather than attenuating local disturbances, these imperfections harm long-term development—and account for many characteristics of the recent crisis.
As an alternative to the traditional full-information model, Greenwald offered a model assuming imperfect information in which an initial shock is followed by a sharp downturn, then a slow recovery. In this model certain policies work well in both the short and the long term, provided an "effective infrastructure of financial institutions" is in place. Because the development of effective financial institutions can both accelerate recovery from a downturn and foster long-term growth, said Greenwald, it should be a primary aim of development assistance.
Asl1 Demirgüç-Kunt and Enrica Detragiache echoed the call for a strong institutional setting before implementing financial market reforms. Efforts to liberalize financial markets, particularly the banking sector, have been high on the economic policy agendas of many countries over the past 30 years. But during this period the frequency of systemic banking problems has markedly increased, raising the possibility that greater fragility is a consequence of liberalization. Studying a large panel data set covering 53 industrial and developing economies during 1980–95, Detragiache and Demirgüç-Kunt found that financial fragility is affected by a host of factors, including adverse macroeconomic developments, poor macroeconomic policies, and vulnerability to balance of payments crises. But even when these factors are controlled for, financial liberalization can be seen to exert an independent negative effect on banking sector stability.
But this negative effect is weaker when the institutional environment is strong, Demirgüç-Kunt and Detragiache found. Respect for the rule of law, low corruption, and good contract enforcement are particularly important to ensure stability. In countries where institutions are not sufficiently developed, "the path to financial liberalization should be a gradual one," they said, even after macroeconomic stability has been achieved. They urged that institutional development be undertaken early in the liberalization process, mainly because strong institutions cannot be created overnight.
Regulating to strengthen competition
The institutional framework is equally important for introducing effective competition in developing economies, conference participants concluded. In the past decade many countries that have transformed state monopolies into private enterprises have been frustrated in their efforts to achieve an efficient market economy. As Stiglitz pointed out, ["turning a state monopoly into a private monopoly is unlikely to help create a more dynamic market economy."] the experience of Russia demonstrates that if privatization is not coupled with competitive markets, it can lead to higher prices, not
lower, and less economic efficiency, not more.While agreeing that the pressure of competition is generally favorable, Jean-Jacques Laffont urged care in implementing competition in the context of weak institutions. Drawing on the insights of modern industrial organization theory, Laffont identified obstacles to development that competition alone cannot overcome—inefficient tax and financial systems, lack of auditing expertise, poor education and technical knowledge, lack of credible governments, and the capture of politicians and bureaucrats. In some sectors, particularly the financial sector, regulation is the essential complement to increased competition, and liberalization can proceed safely only if strong regulatory institutions are in place. While little can be expected in countries where the political will is lacking, elsewhere policymakers must bear in mind that a strong state and competition go hand-in-hand. And as essential as stimulating competition may be, said Laffont, so is building strong democratic institutions that promote the welfare of consumers and avoid interference by interest groups.
The importance of sound regulatory institutions was similarly emphasized by Paul Joskow. In many developing countries efforts to privatize basic network services, such as in water, transport, electricity, and telecommunications, have failed to overcome the tendency of these segments to behave like natural monopolies. These services thus require ongoing regulation aimed at fostering open and nondiscriminatory access to the service network facilities for new competitors.
Looking at Peru’s experience in privatizing its telecommunications systems, Joskow showed that the success of infrastructure reform depends largely on the creation of effective regulatory institutions guided by the principles of independence, transparency, and expertise. These institutions must be established at the outset of reform rather than as an afterthought, and should include
efficient regulatory agencies, appropriate regulatory goals,
a clear role for the regulator, and a credible environment for investors. In general, said Joskow, privatizing infrastructure services works best in an economic environment that protects consumers from exploitation, promotes efficient supply behavior, guards against cross-subsidization and discrimination among competitors, and facilitates competition.
Ethnic diversity and economic performance
The effect of diversity on economic performance was investigated in a study on ethnic conflict by Paul Collier. According to recent evidence, Collier pointed out, ethnic diversity appears to have detrimental microeconomic effects, because it tends to harm public sector performance, increase patronage, and reduce trust among individuals. But diversity’s effect on overall economic growth is less clear-cut, because it depends on the political environment.
Analyzing ethnicity from a highly aggregated, cross-country perspective, Collier found that diversity is not damaging to growth in a democracy. "Democracy effectively eliminates the potentially negative effects of ethnic diversity on economic growth, while the high diversity makes the society even safer from violent conflict than homogeneous societies," he argued. But ethnic diversity can be highly damaging in the context of limited political rights, where the risk of violent conflict is also greater. Once a society reaches full-scale civil war, the balance of influences appears to change, said Collier, and the persistence of conflict and the sustainability of a settlement may depend more on ethnic composition than on income or political rights. Thus in societies driven by violence, maintaining or creating extreme ethnic fractionalization may be the best hope for peace. Collier concluded that the high level of diversity in societies such as many African ones is potentially a source of strength, "as long as they have a high degree of political rights."
Collier’s study shows why it is essential that the Bank’s support to developing economies incorporate an understanding of social and political issues. Ensuring that understanding requires research in a broad range of disciplines—not just economics but also political science and anthropology.
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