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Joseph Stiglitz versus World Bank Group -- Minimalist govts and free-market fundamentalism

From the news release stating that the chief economist and senior vice-president of the World Bank, Mr. Joseph Stiglitz, would leave the organisation at the end of the year, it was clear that he had outworn his welcome. The reason for the World Bank Gro up's disenchantment with its chief economist is quite simple, says Pratap Ravindran: Mr. Stiglitz's penchant for trashing just about every thing sacred to it.

THE WORLD Bank Group, on November 24, 1999, issued a news release stating that the chief economist and senior vice-president of the World Bank, Mr. Joseph Stiglitz, would leave the organisation at the end of the year to return to research and teaching.

The news release quoted the Group president, Mr. James D. Wolfensohn, as saying: ``Joe has an extraordinary mind. He joined the World Bank a year-and-a-half into a major change process designed to move us closer to our clients, away from the so-called Wa shington Consensus, and to apply a comprehensive approach to development putting social justice, equity and the fight against poverty at the heart of the Bank's agenda.

``In the three years that Joe has been with us, he has contributed greatly to that endeavour. It is for that reason that I have asked him to remain as a special advisor to me, and to head the search committee that will look for his successor. I am deligh ted that Joe has agreed to do both. We will miss him greatly, but we will carry on with the work begun five years ago to transform the development business as we know it.'' Mr. Wolfensohn also said, ``...Joe has been an important and strong voice for the interests of the developing countries and especially the poor.''

To those sensitive to the nuances of bureaucratese, it was abundantly clear that, as far as the World Bank Group was concerned, Mr. Stiglitz had long outworn his welcome.

The reason for the World Bank Group's disenchantment with its chief economist was quite simple: Mr. Stiglitz's penchant for trashing just about every thing sacred to it.

A degree of insight into Mr. Stiglitz's value system and economic views _ and the intense discomfiture that they must have caused the World Bank Group _ may be gained from a study of his 1998 WIDER annual lecture _ More instruments and broader goals: Mov ing toward the post-Washington Consensus. In that lecture, Mr. Stiglitz elaborated on the emergence of the `post-Washington Consensus' which, he argued, rested on an improved understanding of what makes markets work well.

The Washington Consensus, it may be recalled, had held that good economic performance required liberalised trade, macroeconomic stability and getting prices right. It had further postulated that with governments getting out of the way, private markets wo uld allocate resources efficiently and generate robust growth.

Mr. Stiglitz, however, had other ideas. He argued that liberalised trade, macroeconomic stability and so on were undoubtedly important for the satisfactory working of markets (``It is very difficult for investors to make good decisions when inflation is running at 100 per cent a year and highly variable'') _ but that the Washington Consensus was not complete and, in certain respects, misguided.

``Making markets work requires more than just low inflation; it requires sound financial regulation, competition policy and policies to facilitate the transfer of technology and to encourage transparency, to cite some fundamental issues neglected by the Washington Consensus.''

There was no stopping Mr. Stiglitz after that. He went on to dismember the Washington Consensus with rare flair: ``Probably the most important policy prescription of the stabilisation packages promoted by the Consensus was controlling inflation. The argu ment for aggressive, pre-emptive strikes against inflation is based on three premises. The most fundamental is that inflation is costly and should, therefore, be averted or lowered.

``The second premise is that once inflation starts to rise, it has a tendency to accelerate out of control. This belief provides a strong motivation for pre-emptive strikes against inflation, with the risk of an increase in inflation being weighed far mo re heavily than the risk of adverse effects on output and employment.

``The third premise is that increases in inflation are very costly to reverse. This line of thought implies that even if maintaining low unemployment were valued more highly than maintaining low inflation, steps would still be taken to keep inflation fro m increasing today to avoid having to induce large recessions to bring the inflation rate down later. All three of these premises can be tested empirically.''

Summarising the detailed evidence available, Mr. Stiglitz observed that high inflation was, indeed, costly and that, when countries cross the threshold of 40 per cent annual inflation, they fall into a high inflation/low growth trap. Below that, however, there is very little evidence that inflation is costly. In fact, recent research (Akerlof, Dickens and Perry) suggests that low levels of inflation may even improve economic performance relative to what it would have been with zero inflation.

Mr. Stiglitz said: ``The evidence of the accelerationist hypothesis is unambiguous; there is no indication that the increase in the inflation rate is related to past increases in inflation. Evidence on reversing inflation suggests that the Phillips curve may be concave and that the costs of reducing inflation may thus be smaller than the benefits incurred when inflation is rising. In my view, the conclusion to be drawn is that controlling high and medium-rate inflation should be a fundamental policy pri ority but that pushing low inflation even lower is not likely to significantly improve the functioning of markets.''

Touching upon the management of budget and current account deficits _ two important constituents of the Washington Consensus _ Mr. Stiglitz pointed out that the three methods of financing deficits all have drawbacks: Internal finance raises domestic inte rest rates, external financing can prove unsustainable and money creation causes inflation.

Further, there is no simple formula for determining the optimum level of the budget deficit. The optimum deficit _ or the range of sustainable deficits _ depends on circumstances, including the cyclical state of the economy, prospects for future growth, the uses of government spending, the depth of financial markets, and the levels of national savings and national investment.

Ironically, according to Mr. Stiglitz, macroeconomic stability as conceived by the Washington Consensus downplays stabilising output or employment. Minimising or avoiding major economic contractions should be one of the most important goals of policy. In the short run, large-scale involuntary unemployment is clearly inefficient _ in purely economic terms, it represents idle resources that could be used more productively. The social and economic costs of these downturns can be devastating; lives and fami lies are disrupted, poverty increases, living standards decline and, in the worst cases, social and economic costs translate into political and social turmoil.

How, then, can macroeconomic stability in the sense of stable output or employment be promoted? The traditional answer, according to Mr. Stiglitz, is good macroeconomic policy, including counter-cyclical monetary policy and fiscal policy that allows auto matic stabilisers to operate.

``These policies are certainly necessary, but a growing literature, both theoretical and empirical, has emphasised the important microeconomic underpinnings of macroeconomic stability. This literature emphasises the importance of financial markets and ex plains economic downturns through such mechanisms as credit rationing and banking and firm failures.''

Financial reform

Mr. Stiglitz's views on the process of financial reform are highly stimulating _ except, perhaps, to the World Bank Group. The importance of building robust financial systems, according to him, goes beyond simply averting economic crises. The financial s ystem can be likened to the `brain' of the economy. It plays an important role in collecting and aggregating savings from agents who have excess resources. These resources are allocated to others _ entrepreneurs, for instance _ who can make productive us e of them.

Well-functioning financial systems do a very good job of selecting the most productive recipients for these resources. In contrast, poorly-functioning ones often allocate capital to low-productivity investments. Selecting projects is only the first stage . The financial system must continue to monitor the use of funds, ensuring that they continue to be used productively. In the process, financial markets serve a number of other functions, including reducing risk, increasing liquidity and conveying inform ation. All of these functions are essential to both the growth of capital and the increase in total factor productivity.

And then, the punchline: ``Left to themselves, financial systems will not do a very good job of performing these functions. Problems of incomplete information, incomplete markets, and incomplete contracts are all particularly severe in the financial sect or, resulting in an equilibrium that is not even constrained Pareto efficient.''

Further, transparency by itself is also not sufficient to ensure the effective functioning of markets. A sound legal framework combined with regulation and oversight is necessary to mitigate informational problems and foster the conditions for an efficie nt financial market.

The purposes of regulation

It is in the context of this position that Mr. Stiglitz asserts that regulation serves four purposes: Maintenance of safety, promotion of competition, protection of consumers and access to capital for the under-served.

At this point, Mr. Stiglitz's divergence from the World Bank Group's thinking grows more pronounced. ``The Washington Consensus developed in the context of highly regulated financial systems in which many of the regulations were designed to limit competi tion rather than promote any of the four legitimate objectives of regulation. But, all too often, the dogma of liberalisation became an end in itself, not a means of achieving a better financial system...''

(To be concluded)