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Stanford Report, September 30, 1998

New center focuses on development crises: 9/98

Economists debate practical questions, approaches to Asian economic crises

BY KATHLEEN O'TOOLE

Aaron Tornell snatched his namecard from the conference table and stood it on end, signaling his eagerness to ask a question.

"OK, I'm a policymaker in Mexico with a state-owned telephone company," he began, even though he is really a newly minted assistant professor of economics. "You tell me there are these four things I need to successfully privatize the company, but what if I can't do all four things? Do I go ahead anyway?"

Such practical, politically driven questions took center stage at the inaugural conference earlier this month of the Stanford Center for Research on Economic Development and Policy Reform. The center, under the leadership of economist Anne Krueger, opened for business just 20 months ago ­ in another era. Back then, newspapers still referred to the "Asian miracle," not the "Asian crisis," and the question economists debated was how soon other countries could expect success. Today's questions expose large knowledge gaps in the academic literature dedicated to raising the standard of living in the world's poorer nations.

The Asian crisis that began with the sudden depreciation of the Thai bhat in the summer of 1997, followed by a similar run on the Russian ruble this summer and the spread of fear to investors in Latin America since, also spawned a crisis of confidence in Western academic ideas, warned Joseph Stiglitz, a Stanford economist on leave to serve as vice president and chief economist of the World Bank. New distrust will make it more difficult for even well-grounded economic ideas to be implemented in these countries, he said in a dinner speech on Sept. 17 that some of his colleagues described as a "diatribe" or "catalog" of the excesses of recent liberalization reform advice.

Stiglitz permitted reporters to attend on the condition they only paraphrase his comments. He has "tried to temper his public statements" in recent months, the Wall Street Journal recently reported, because his earlier criticisms of the Asian bailout policies of the Clinton administration and the International Monetary Fund ruffled feathers in Washington, where he was previously chairman of Clinton's Council of Economic Advisers. But the Journal also reported that the "puckish Stanford professor" recently presented an "academic-style assault on the Treasury-IMF orthodoxy" at the Brookings Institution, apparently similar to the assault he presented here.

New colonialism

Stiglitz now travels routinely to developing countries, where he finds increasing suspicion that Western advice on economic reform is the backbone of a new form of colonialism, he told his Stanford audience. While he didn't agree with that assessment, he said that Western advisers have too often based their advice on ideology and outrun the research data available to support it.

Respected for his research that demonstrates why many types of free markets fail without some form of government regulation, Stiglitz suggested that the economists and political scientists in his audience pay more attention to how to create the institutions that regulate a liberalized economy. He was also critical of policymakers for imposing painful reforms on developing countries that they were not willing to impose during bad times at home, such as during the 1989 savings and loan crisis.

The keynote speech drew mixed reviews over the course of the three-day conference, but most of the three dozen participants seemed to agree that market liberalization had taken a beating in the court of world opinion. Rejuvenating its reputation, they said, would require, among other things, diligent building of a better research base.

"It's certainly true that the cause of market liberalization has been set back by this catastrophe," said Stanford economist Ronald McKinnon, whose expertise is in monetary policy. "Past liberalization was done without proper regulatory practices in place, so we have this breakdown of the banking system and hot money flows. As Joe suggested, we have to be very careful about what reform means, more sober and less exuberant."

On the other hand, learning typically flows from new experience and comes in stages, said Krueger, the conference organizer. She is widely respected for her research in the '70s that helped established how developing countries hurt themselves with protective international trade policies. Trade liberalization is one area where there is now a strong body of evidence to support it, she and Stiglitz agreed, but public sentiment in favor of protecting domestic businesses from competition still thwarts free trade from time to time, even in the United States.

"At first the question was, Do you do trade liberalization?" Krueger recalled. "That gets established. Then the next question was, How big is the impact? Answer: Not very big. Next question: But people are afraid of it, so what do you do? We still don't really have a good political answer as to how you respond to [fears]. I'm sure if we get an answer to that, we'll find some other questions."

Bankers' shortcomings

Trade questions took a back seat at this conference to those directly related to the liquidity crisis. The problem of how to make banks more responsible for their borrowing and lending was clearly on the front burner as well as the advisability of countries permitting their citizens and foreigners to move capital in and out.

Other issues discussed related to the equity and political viability of market reforms. The pain and gain of reforms has not been distributed equally, speakers said, prompting backsliding on commitments in some cases. Some participants advised giving compensation to groups most likely to be hurt by reforms in the short run, such as workers in previously protected industries, while others focused on how to keep the "winners" in check.

In Russia, several participants noted, it was the winners, not the losers, who blocked later stages of reform. Managers and owners of hastily privatized companies gained incentives and resources to fight later changes. A vicious circle developed because these winners, not convinced of the sustainability of reforms, converted industrial assets to their own use and moved them out of the country, several speakers alleged. This summer's IMF loan to Russia to fight currency devaluation is now widely viewed as having provided the Russian oligarchy and some foreign investors with an opportunity to take investment capital out of Russia. The country also has not seen the typical reform pattern in labor markets where workers move out of old, inefficient industries into newer, more profitable ones, said Edward Lazear, a labor economist at the Stanford Graduate School of Business.

The disaster in Russia prompted some conference participants to advocate more rapid-paced reforms. "In times of crisis, technocrats have greater room to maneuver for good or bad," Krueger said, arguing for speed. Others pointed to the success of China's slower paced reform that emphasized building market competition before privatization of state-owned enterprises. Stiglitz, in particular, was critical of privatization without competition, which allows privatized firms to extract monopoly prices from the rest of society. Stanford economist Roger Noll also questioned the wisdom of IMF advice to Mexico to set up a monopoloy phone company so it could extract higher taxes from it.

"My view of the evidence on gradualism versus speed is that there is none worth the paper it is printed on," said Abhijit Banerjee, an economist from the Massachusetts Institute of Technology, who offered the view that economics tends to overemphasize "management" and overlook the role of "innovation" in the reform process. Stephen Haggard, a political scientist from the University of California-San Diego, suggested that the research was poorly developed also on how to design institutions, such as bankruptcy courts, accounting systems and tax collection agencies, so they could not be corrupted.

Tornell of Harvard, a fellow last year at the Stanford center, noted the failure of privatization to stick in many places because of the "moral hazards" involved. Mexico privatized its airline into two companies, then had to take it back because of the over-borrowing of one company and the merger of both. The government now faces reprivatizing them, and there is no magic formula for ensuring the same thing won't happen again, he said.

Others criticized a large body of literature emphasizing the role of interest groups in reforms. While it shed light on how coalitions form to support good or bad reforms, they said, it failed to take into account the role of "political entrepreneurs" such as Margaret Thatcher in Great Britain, the power of "innovative ideas" that catch fire after one country demonstrates success or the sudden disappearance from battle of some interest groups. Still others criticized the research for assuming government officials and their Western-trained technical advisers were benevolent agents or referees of change with no vested interests of their own.

"Economic development policy research started off with an exclusive focus on improving economic performance," noted Noll, who heads Stanford's public policy program. "Later, it evolved to look at the levers [government officials can use] to get policy control. The next step was to recognize the levers are not independent variables, but determined by politics."

Political science lacks a "taxonomy of policy reform" since Marxism collapsed, Stanford political scientist Stephen Krasner said. New approaches pioneered by Stanford's Barry Weingast and others to look at the historical situation of a country and then apply rational economic analysis add impressive insights, he said, "but I have no idea how to do this systematically."

Hindsight consensus

A "consensus in hindsight" has developed, McKinnon said, and it established that "the rush to privatize banks in the late '80s and early '90s was ill advised. You get private banks taking big risks by accepting short-term loans in dollars and yen and then re-loaning them in the country's own currency at higher interest rates. There is no guarantee a government bank wouldn't do same thing, but the incentive structure is different."

Economists also seem to agree that lifting controls on capital flows is not a good idea for newly liberalized economies. McKinnon published a book in 1991 that said removing capital controls should be the last step in a reform process, advice that the IMF and most countries ignored. But, he said, that doesn't mean countries that have opened their doors to foreign capital and allowed citizens to take capital out should temporarily go back to controls, a suggestion made recently by MIT economist Paul Krugman. Removing controls creates "a terrific incentive to overborrow," McKinnon said. "China prevented that and is an oasis of stability in Asia, but once you build up this big debt, it gets everybody mad at you to suddenly freeze it and not repay, and if you put in controls on taking capital out of the country, you can't get any new capital in."

One thing that would help the Asian debtor nations to stabilize their currencies, McKinnon said, would be for the United States and Japan to announce their intent to keep the yen and the dollar trading long term in a stable range. "There is a kind of system failure going on for the world as a whole" that goes beyond the internal problems of developing countries, he said.

Stiglitz repeated some of his earlier criticism of the International Monetary Fund. Like a few other prominent American economists who are known as political liberals, he has criticized the fund for imposing austerity measures on Asian debtor nations in exchange for emergency loans. Forcing them to balance government budgets and raise interest rates deepens their recessions and hurts small business and the poor the most, he said. But others at the conference said the IMF has no choice until someone comes up with a better strategy for restoring investors confidence in the targeted economies.

The conference will lead to a book, Krueger said, with the intention of helping researchers set new agendas. Stiglitz praised Krueger for expanding the center's discussion to involve economists who don't ordinarily deal with the economic issues of developing countries. As examples, he pointed to Roger Noll, a specialist on industrial organization who ordinarily works on U.S. regulatory policy issues, and Edward Lazear, an expert on labor markets. "It's important to involve them both from the perspective of what understanding they might bring to the development process but also because studying development generates an enormous number of ideas important to economics more generally," Stiglitz said during a conference break.

While there are other centers that focus on specific geographic regions and a Harvard center that focuses on providing direct advice to developing countries, he said, the Stanford center is important because of its focus on filling research gaps. SR