More Instruments and Broader Goals: Moving Toward the

Post–Washington Consensus

Joseph Stiglitz, Senior Vice President and Chief Economist

The World Bank
January 7, 1998
The 1998 WIDER Annual Lecture (Helsinki, Finland)

I would like to discuss improvements in our understanding of economic

development, in particular the emergence of what is sometimes called the “post–
Washington consensus.” My remarks elaborate on two themes. The first is that we have
come to a better understanding of what makes markets work well. The Washington
consensus held that good economic performance required liberalized trade,
macroeconomic stability, and getting prices right (see Williamson 1990). Once the
government dealt with these issues— essentially, once the government “got out of the
way”— private markets would allocate resources efficiently and generate robust growth.
To be sure, all of these are important for markets to work well: it is very difficult for
investors to make good decisions when inflation is running at 100 percent a year and
highly variable. But the policies advanced by the Washington consensus are not
complete, and they are sometimes 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.
Our understanding of the instruments to promote well-functioning markets has
also improved, and we have broadened the objectives of development to include other
goals, such as sustainable development, egalitarian development, and democratic
development. An important part of development today is seeking complementary
strategies that advance these goals simultaneously. In our search for these policies,
however, we should not ignore the inevitable tradeoffs. This is the second theme I will
address.
Some Lessons of the East Asian Financial Crisis

Before discussing these themes, I would like to address the implications of the
current East Asian crisis for our thinking about development. Observation of the
successful, some even say miraculous, East Asian development was one of the
motivations for moving beyond the Washington consensus. After all, here was a regional
cluster of countries that had not closely followed the Washington consensus prescriptions
but had somehow managed the most successful development in history. To be sure,
many of their policies— such as low inflation and fiscal prudence— were perfectly in line
with the Washington consensus. Several aspects of their strategy, such as an emphasis on
egalitarian policies, while not at odds with the Washington consensus, were not
emphasized by it. Their industrial policy, designed to close the technological gap
between them and the more advanced countries, was actually contrary to the spirit of the
Washington consensus. These observations were the basis for the World Bank’s East
Asian Miracle study (World Bank 1993), and it stimulated the recent rethinking of the
role of the state in economic development.
Since the financial crisis the East Asian economies have been widely condemned
for their misguided economic policies, which are seen as responsible for the mess in
which those economies find themselves today. Some ideologues have taken advantage of
the current problems in East Asia to suggest that the system of active state intervention is
the root of the problem. They point to the government-directed loans and the cozy
relations between the government and the large chaebol in the Republic of Korea. In
doing so, they overlook the successes of the past three decades, to which the government,
despite occasional mistakes, has certainly contributed. These achievements, which
include not only large increases in per capita GDP but also increases in life expectancy,
the extension of education, and a dramatic reduction in poverty, are real and will prove
more lasting than the current financial turmoil.
Even when the governments directly undertook actions themselves, they had
notable achievements. The fact that they created the most efficient steel plants in the
world challenges the privatization ideologues who suggested that such successes are at
best a fluke, and at worst impossible. Nevertheless, I agree that, in general, government

2
should focus on what it alone can do and leave the production of commodities like steel
to the private sector. But the heart of the current problem in most cases is not that
government has done too much in every area but that it has done too little in some areas.
In Thailand the problem was not that the government directed investments into real
estate; it was that government regulators failed to halt it. Similarly, the Republic of
Korea suffered from problems including overlending to companies with excessively high
leverage and weak corporate governance. The fault is not that the government
misdirected credit – the fact the current turmoil was precipitated by loans by so many
U.S., European and Japanese banks suggest that market entities also may have seriously
misdirected credit. Instead the problem was the government’s lack of action, the fact
that the government underestimated the importance of financial regulation and corporate
governance.1
The current crisis in East Asia is not a refutation of the East Asian miracle. The
basic facts remain: no other region in the world has ever had incomes rise so dramatically
and seen so many people move out of poverty in such a short time. The more dogmatic
versions of the Washington consensus fail to provide the right framework for
understanding either the success of the East Asian economies or their current troubles.
Responses to East Asia’s crisis grounded in these views of the world are likely to be, at
best, badly flawed and, at worst, counterproductive.

1
There are, to be sure, many other dimensions to the turmoil. Misguided foreign exchange policies and the
potential for political instability are a few other significant issues that I discuss at more length in Stiglitz
(1998).

3
Making Markets Work Better

The Washington consensus was catalyzed by the experience of Latin American

countries in the 1980s. At the time markets in the region were not functioning well,
partly the result of dysfunctional public policies. GNP declined for three consecutive
years. Budget deficits were very high— some were in the range of 5–10 percent of
GDP2— and the spending underlying them was being used not so much for productive
investments as for subsidies to the huge and inefficient state sector. With strong curbs on
imports and relatively little emphasis on exports, firms had insufficient incentives to
increase efficiency or maintain international quality standards. At first deficits were
financed by borrowing— including very heavy borrowing from abroad. Bankers trying to
recycle petrodollars were quick to lend and low real interest rates made borrowing very
attractive, even for low-return investments. After 1980, though, real interest rate
increases in the United States restricted continued borrowing and raised the burden of
interest payments, forcing many countries to turn to seignorage to finance the gap
between the continued high level of public spending (augmented by soaring interest
payments) and the shrinking tax base. The result was very high and extremely variable
inflation. In this environment money became a much costlier means of exchange,
economic behavior was diverted toward protecting value rather than making productive
investments, and the relative price variability induced by the high inflation undermined
one of the primary functions of the price system: conveying information.
The so-called “Washington consensus” of U.S. economic officials, the
International Monetary Fund (IMF), and the World Bank was formed in the midst of
these serious problems. Now is a good time to reexamine this consensus. Many
countries, such as Argentina and Brazil, have pursued successful stabilizations; the
challenges they face are in designing the second generation of reforms. Still other
countries have always had relatively good policies or face problems quite different from
those of Latin America. East Asian governments, for instance have been running budget
surpluses; inflation is low and, before the devaluations, was falling in many countries

2
Argentina, for example, had a deficit of over 5 percent of GDP in 1982 and 7 percent in 1983, Colombia’s
budget deficit was over 4 percent from 1982 to 1984, and Brazil’s deficit increased from 11 percent in 1985

4
(see figures 1 and 2). The origins of the current financial crises lie elsewhere and their
solutions will not be found in the Washington consensus.
The focus on inflation— the central macroeconomic malady of the Latin American
countries, which provided the backdrop for the Washington consensus— has led to
macroeconomic policies that may not be the most conducive for long-term economic
growth, and it has detracted attention from other major sources of macro-instability,
namely, weak financial sectors. In the case of financial markets the focus on freeing up
markets may have had the perverse effect of contributing to macroeconomic instability by
weakening the financial sector. More broadly, in focusing on trade liberalization,
deregulation, and privatization, policymakers ignored other important ingredients, most
notably competition, that are required to make an effective market economy and which
may be at least as important as the standard economic prescriptions in determining long-
term economic success. 3
Other essential ingredients were also left out or underemphasized by the
Washington consensus. One— education— has been widely recognized within the
development community; others, such as the improvement of technology, may not have
received the attention they deserve.
The success of the Washington consensus as an intellectual doctrine rests on its
simplicity: its policy recommendations could be administered by economists using little
more than simple accounting frameworks. A few economic indicators— inflation, money
supply growth, interest rates, budget and trade deficits— could serve as the basis for a set
of policy recommendations. Indeed, in some cases economists would fly into a country,
look at and attempt to verify these data, and make macroeconomic recommendations for
policy reforms all in the space of a couple of weeks.4
There are important advantages to the Washington consensus approach to policy

to 16 percent by 1989 (World Bank, 1997d).

3
See Vickers and Yarrow (1988) for a fuller discussion of privatization, competition, and incentives.
4
These issues came up in the management of the U.S. economy. Although much research showed that the
United States was able to operate at lower levels of unemployment without an acceleration of inflation,
reports from some international institutions, using oversimplified models of the U.S. economy,
recommended tightening monetary policy. Had this advice been followed, the remarkable economic
expansion, and the resulting low unemployment rate which has brought marginalized groups into the labor
force, reduced poverty, and contributed substantially to the reduction of welfare rolls, would all have been
thwarted (see Chapter 2 of the Economic Report of the President 1997 for some of this analysis).

5
advice. It focuses on issues of first-order importance, it sets up an easily reproducible
framework which can be used by a large organization worried about recommendations
depending on particular individuals’ viewpoints, and it is frank about limiting itself only
to establishing the prerequisites for development. But the Washington consensus does
not offer answers to every important question in development.
In contrast, the ideas that I present here are, unfortunately, not so simple. They
are not easy to articulate as dogma nor to implement as policy. There are no easy-to-read
thermometers of the economy’s health, and worse still, there may be trade-offs, in which
economists, especially outside economists, should limit their role to describing
consequences of alternative policies. The political process may actually have an
important say in the choices of economic direction. Economic policy may not be just a
matter for technical experts! These conflicts become all the more important when we
come to broaden the objectives, in the final part of this talk.
This part of the paper focuses on enhancing the efficiency of the economy. I will
discuss macro-stability and liberalization— two sets of issues which the Washington
consensus was concerned about— as well as financial sector reform, the government’s
role as a complement to the private sector, and improving the state’s effectiveness—
issues that were not included in the consensus. I shall argue that the Washington
consensus’ messages in the two core areas are at best incomplete and at worse misguided.
While macro-stability is important, for example, inflation is not always its most essential
component. Trade liberalization and privatization are key parts of sound macro-
economic policies, but they are not ends in themselves. They are means to the end of a
less distorted, more competitive, more efficient marketplace and must be complemented
by effective regulation and competition policies.

Achieving Macroeconomic Stability

Controlling inflation. Probably the most important policy prescription of the stabilization
packages promoted by the Washington consensus was controlling inflation. The
argument for aggressive, preemptive strikes against inflation is based on three premises.
The most fundamental is that inflation is costly and should therefore be averted or

6
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 preemptive strikes
against inflation, with the risk of an increase in inflation being weighed far more heavily
than the risk of adverse effects on output and unemployment. 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 from increasing today in order to avoid having
to induce large recessions to bring the inflation rate down later on. All three of these
premises can be tested empirically.
I have discussed this evidence in more detail elsewhere (Stiglitz 1997a). Here I
would like to summarize briefly. The evidence has shown only that high inflation is
costly. Bruno and Easterly (1996) found that when countries cross the threshold of 40
percent annual inflation, they fall into a high-inflation/low-growth trap. Below that level,
however, there is little evidence that inflation is costly. Barro (1997) and Fischer (1993)
also confirm that high inflation is, on average, deleterious for growth, but they, too, fail to
find any evidence that low levels of inflation are costly. Fischer finds the same results
for the variability of inflation.5 Recent research by Akerlof, Dickens, and Perry (1996)
suggests that low levels of inflation may even improve economic performance relative to
what it would have been with zero inflation.
The evidence on the accelerationist hypothesis (also known as “letting the genie
out of the bottle,” the “slippery slope,” or the “precipice theory”) 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.6

5
Because the level and variability of inflation are correlated, Fischer reported great difficulty in
disentangling their separate effects at any level/variance of inflation. This point holds true generally: any
study of the consequences of inflation probably also picks up costs associated with the variability of
inflation.
The strength of nonlinearity in the relationship between inflation and social welfare is clear from
the outcome of research conducted by the U.S. Federal Reserve Bank. Despite the efforts of their first-rate
economists— some of them working full time on the costs of inflation— the Fed has still failed to find
definitive evidence of costs of inflation in the United States. Should they eventually succeed in finding
such results, they will have proven only that data mining works, not that inflation is costly.
6
See Stiglitz (1997c) discusses the evidence in the United States. Tentative research at the World Bank

7
 In my view the conclusion to be drawn from this research is that controlling high
and medium-rate inflation should be a fundamental policy priority but that pushing low
inflation even lower is not likely to significantly improve the functioning of markets.
In 1995 more than half the countries in the developing world had inflation rates of
less than 15 percent a year (figure 3). For these 71 countries controlling inflation should
not be a overarching priority. Controlling inflation is probably an important component
of stabilization and reform in the 25 countries, almost all of them in Africa, Eastern
Europe, and the former Soviet Union, with inflation rates of more than 40 percent a year.
The single-minded focus on inflation may not only distort economic policies—
preventing the economy from living up to its full growth and output potentials— but also
lead to institutional arrangements that reduce economic flexibility without gaining
important growth benefits.7

Managing the budget deficit and the current account deficit. A second
component of macroeconomic stability has been reducing the size of government, the
budget deficit, and the current account deficit. I will return to the issue of the optimal
size of government later; for now I would like to focus on the twin deficits. Much
evidence shows that sustained, large budget deficits are deleterious to economic
performance (Fischer 1993; Easterly, Rodriguez, and Schmidt-Hebbel 1994).8 The three
methods of financing deficits all have drawbacks: internal finance raises domestic interest

discussed in Stiglitz (1997a) extends the results to a number of other countries, including Australia,
Canada, France, Germany, Italy, Japan, and Brazil. Mexico was the only country with adequate data to run
the tests where the Phillips curve appeared convex.
7
Some have argued that central banks should have an exclusive mandate to maintain price stability. This
perspective has even been introduced into IMF programs in economies such as Korea with no history of an
inflation problem. There is no evidence that such constraints (whether embodied in legislation or formal
commitments such as inflation targets) improve real economic performance as measured by growth (see
Alesina and Summers, 1993). Such results are consistent with the earlier empirical evidence concerning
the real effects of inflation. More importantly, these issues involve fundamental political judgments,
values, and trade-offs in addition to technical expertise. For example, I— as well as most other members of
the Clinton Administration’s economics team— strongly opposed proposals to change the charter of the
Federal Reserve Board to make price stability its primary or sole mandate. Such proposals might well have
been the center of a major political debate if they had been pushed. See Stiglitz (1997a) for a broader
discussion of these issues.
8
The theoretical literature on Ricardian equivalence (Barro, 1974) criticizes the view that the deficit by
itself has significant economic effects. The Washington consensus was not based on models that explicitly
addressed the issue of Ricardian equivalence.

8
rates, external financing can be unsustainable, and money creation causes inflation.9
There is no simple formula for determining the optimum level of the budget
deficit. The optimum deficit— or the range of sustainable deficits10— 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. The United States, for example, is currently
trying to balance its budget. I have long argued that the low private saving rate and the
aging of the baby boom suggest that the United States should probably be aiming for
budget surpluses. In contrast, the case for maintaining budget surpluses in the East Asian
countries in the face of an economic downturn, where the rate of private saving is high
and the public debt-GDP ratios are relatively low, is far less compelling.
The experience of Ethiopia emphasizes another determinant of optimal deficits,
the source of financing. For the last several years Ethiopia has a run a deficit of about 8
percent of GDP. Some outside policy advisers would like Ethiopia to lower its deficit.
Others have argued that the deficit is financed by a steady and predictable inflow of
highly concessional foreign assistance, which is driven not by the necessity of filling a
budget gap but by the availability of high returns to investment. Under these
circumstances— and given the high returns to government investment in such crucial
areas as primary education and physical infrastructure (especially roads and energy)— it
may make sense for the government to treat foreign aid as a legitimate source of revenue,
just like taxes, and balance the budget inclusive of foreign aid.
The optimal level of the current account deficit is difficult to determine. Current
account deficits occur when a country invests more than it saves. They are neither
inherently good nor inherently bad but depend on circumstances and especially on the
uses to which the funds are put. In many countries the rate of return on investment far

9
Easterly and Fischer (1990) summarize the simple analytics of the macroeconomic effects of government
budget deficits.
10
I use the terms optimum and sustainable loosely. In this context, “sustainable” does not necessarily mean
“sustained” at a high level indefinitely. Rather, it refers to situations such as when large deficits are used to
stimulate the economy out of an economic downturn expected to be of short duration. “Optimum” has to
be defined relative to a clearly articulated objective such as maximizing in an intertemporal social welfare
function. There are circumstances and reasonable social welfare functions that give markedly different
values for today’s optimal level of deficit — one cannot assert that desirable level of deficit without
knowing both factors. The same observation applies to the following discussion of the optimal level of the
current account deficit.

9
exceeds the cost of international capital. In these circumstances current account deficits
are sustainable.11
The form of the financing also matters. The advantage of foreign direct
investment is not just the capital and knowledge that it supplies, but also the fact that it
tends to be very stable. In contrast, Thailand’s 8 percent current account deficit in 1996
was not only large but came in the form of short-term, dollar-denominated debt that was
used to finance local-currency denominated investment, often in excessive and
unproductive uses like real estate. More generally, short-term debt and portfolio flows
can bring the costs of high volatility without the benefits of knowledge spillovers.12

Stabilizing output and promoting long-run growth. Ironically, macroeconomic

stability— as conceived by the Washington consensus— typically downplays stabilizing
output or unemployment. Minimizing 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 families are disrupted, poverty increases, living
standards decline, and, in the worst cases, social and economic costs translate into
political and social turmoil.
Moreover, business cycles themselves can have important consequences for long-
run growth (see Stiglitz 1994a). The difficulty of borrowing to finance research and
development means that firms will need to reduce drastically their research and
development expenditures when their cash flow decreases in downturns. The result is
slower total factor productivity growth in the future. This effect appears to have been
important in the United States; whether or not it matters in countries in which research
and development plays a less important role requires further study. Generally, however,
variability of output almost certainly contributes to uncertainty and thus discourages

11
The current account deficit is an endogenous variable. Assessing whether it is too “high” depends on the
source of its size. If, for example, misguided foreign exchange policies account for the deficit, it is too
high.
12
Traditional government macro-policies focus on aggregates such as capital flows and budget deficits and
do not deal directly with these issues. If the maturity structure of foreign borrowing leads to significant
risks, other capital restraints or interventions may be necessary.

10
investment.13
Variability of output is especially pronounced in developing countries (see
Pritchett 1997). The median high-income country has a standard deviation of annual
growth of 2.8 percent (figure 4). For developing countries the standard deviation is 5
percent or higher, implying huge deviations in the growth rate. Growth is especially
volatile in Europe and Central Asia, the Middle East and North Africa, and Sub-Saharan
Africa.
How can macroeconomic stability in the sense of stabilizing output or
employment be promoted? The traditional answer is good macroeconomic policy,
including countercyclical monetary policy and a fiscal policy that allows automatic
stabilizers to operate. These policies are certainly necessary, but a growing literature,
both theoretical and empirical, has emphasized the important microeconomic
underpinnings of macroeconomic stability. This literature emphasizes the importance of
financial markets and explains economic downturns through such mechanisms as credit
rationing and banking and firm failures.14
In the nineteenth century most of the major economic downturns in industrial
countries resulted from financial panics that were sometimes preceded by and invariably
led to precipitous declines in asset prices and widespread banking failures. In some
countries improvement in regulation and supervision, the introduction of deposit
insurance, and the shaping of incentives for financial institutions reduced the incidence
and severity of financial panics. But financial crises continue to occur, and there is some
evidence that they have become more frequent and more severe in recent years (Caprio
and Klingebiel 1997). Even after adjusting for inflation, the losses from the notorious
savings and loan debacle in the United States were several times larger than the losses
experienced in the Great Depression. Yet when measured relative to GDP, this debacle

13
There are also other channels through which economic downturns leave a longer term adverse legacy: the
attrition of human capital has, for instance, been emphasized in the literature on the hysteresis effect and
may be a factor in the sustained high levels of unemployment in Europe (see Blanchard and Summers,
1987). As I discuss in the following section, economic downturns, when severe enough, can undermine the
strength of the financial system.
14
In the Great Depression, falling prices combined with fixed interest payments reduced firms’net cash
flows, eroding net worth, and decreasing their investment and further weakening the economy. As a result,
these models are sometimes called debt-deflation models. See Greenwald and Stiglitz (1988, 1993a,
1993b).

11
would not make the list of the top 25 international banking crises since the early 1980s
(table 1).
Banking crises have severe macroeconomic consequences, affecting growth over
the five following years (figure 5). During the period 1975–94 growth edged up slightly
in countries that did not experience banking crises; countries with banking crises saw
growth slow by 1.3 percentage points in the five years following a crisis. Clearly,
building robust financial systems is a crucial part of promoting macroeconomic stability.

The Process of Financial Reform

The importance of building robust financial systems goes beyond simply averting
economic crises. The financial system 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 today. These resources are allocated to others— such as entrepreneurs
and home builders— who can make productive use of them. Well-functioning financial
systems do a very good job of selecting the most productive recipients for these
resources. In contrast, poorly functioning financial systems 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 information. All of these
functions are essential to both the growth of capital and the increase in total factor
productivity.
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 sector, resulting in an
equilibrium that is not even constrained Pareto efficient (Greenwald and Stiglitz 1986).15
The emphasis on “transparency” in recent discussions of East Asia demonstrates

15
The term constrained Pareto efficient means that there are (in principle) government interventions which
can make some people better off without making anyone else worse off which respect the imperfections of
information and the incompleteness of markets— and more broadly, the costs of offsetting these
imperfections.

12
our growing recognition of the importance of good information for the effective function
of markets. Capital markets, in particular, require auditing standards accompanied by
effective legal systems to discourage fraud, provide investors with adequate information
about the firms’assets, liabilities, and protect minority shareholders.16 But transparency
by itself is not sufficient, in part because information is inevitably imperfect. A sound
legal framework combined with regulation and oversight is necessary to mitigate these
informational problems and foster the conditions for efficient financial markets.
Regulation serves four purposes in successful financial markets: maintaining
safety and soundness (prudential regulation), promoting competition, protecting
consumers, and ensuring that underserved groups have some access to capital. In many
cases the pursuit of social objectives— such as ensuring that minorities and poor
communities receive funds, as the United States’Community Reinvestment Act does, or
ensuring funds for mortgages, the essential mission of the government-created Federal
National Mortgage Association— can, if done well, reinforce economic objectives.
Similarly, protecting consumers is not only good social policy, it also builds confidence
that there is a “level playing field” in economic markets. Without such confidence those
markets will remain thin and ineffective.
At times, however, policymakers face tradeoffs among conflicting objectives.
The financial restraints adopted by some of the East Asian economies, for example,
increased the franchise values of banks, discouraging them from taking unwarranted risks
that otherwise might have destabilized the banking sector. Although there were
undoubtedly some economic costs associated with these restraints, the gains from greater
stability almost surely outweighed those losses. As I comment below, the removal of
many of these restraints in recent years may have contributed in no small measure to the
current instability that these countries are experiencing.
The World Bank and others have tried to create better banking systems. But
changing the system— through institutional development, transformations in credit
culture, and creation of regulatory structures which reduce the likelihood of excessive

16
For a fuller discussion of the role of these protections as part of the basic architecture of modern
capitalism, see Greenwald and Stiglitz (1992).

13
risk-taking17 — has proved more intractable than finding short-term solutions, such as
recapitalizing the banking system. In the worst cases the temporary fixes may even have
undermined pressures for further reform. Since the fundamental problems were not
addressed, some countries have required assistance again and again.
The Washington consensus developed in the context of highly regulated financial
systems, in which many of the regulations were designed to limit competition rather than
promote any of the four legitimate objectives of regulation. But all too often the dogma
of liberalization became an end in itself, not a means of achieving a better financial
system. I do not have space to delve into all of the many facets of liberalization, which
include freeing up deposit and lending rates, opening up the market to foreign banks, and
removing restrictions on capital account transactions and bank lending. But I do want to
make a few general points.
First, the key issue should not be liberalization or deregulation but construction of
the regulatory framework that ensures an effective financial system. In many countries
this will require changing the regulatory framework by eliminating regulations that serve
only to restrict competition but accompanying these changes with increased regulations
to ensure competition and prudential behavior (and to ensure that banks have appropriate
incentives.)
Second, even once the design of the desired financial system is in place, care will
have to be exercised in the transition. Attempts to initiate overnight deregulation—
sometimes known as the “big bang”— ignore the very sensitive issues of sequencing.
Thailand, for instance, used to have restrictions on bank lending to real estate. In the
process of liberalization it got rid of these restrictions without establishing a more
sophisticated risk-based regulatory regime. The result, together with other factors, was
the large-scale misallocation of capital to fuel a real estate bubble, an important factor in
the financial crisis.
It is important to recognize how difficult it is to establish a vibrant financial
sector. Even economies with sophisticated institutions, high levels of transparency, and
good corporate governance like the United States and Sweden have faced serious
problems with their financial sectors. The challenges facing developing countries are far

17
This is sometimes referred to as the problem of moral hazard.

14
greater, while the institutional base from which they start is far weaker.
Third, in all countries a primary objective of regulation should be to ensure that
participants face the right incentives: government cannot and should not be involved in
monitoring every transaction. In the banking system liberalization will not work unless
regulations create incentives for bank owners, markets, and supervisors to use their
information efficiently and act prudentially.
Incentive issues in securities markets also need to be addressed. It must be more
profitable for managers to create economic value than to deprive minority shareholders of
their assets: rent seeking can be every bit as much a problem in the private as in the
public sector. Without the appropriate legal framework, securities markets can simply
fail to perform their vital functions— to the detriment of the country’s long-term
economic growth. Laws are required to protect the interests of shareholders, especially
minority shareholders.
The focus on the microeconomic, particularly the financial, underpinnings of the
macroeconomy also has implications for responses to currency turmoil. In particular,
where currency turmoil is the consequence of a failing financial sector, the conventional
policy response to rising interest rates may be counterproductive.18 The maturity and
structure of bank and corporate assets and liabilities are frequently very different, in part
because of the strong incentives for banks to use short-term debt to monitor and influence
the firms they lend to and for depositors to use short-term deposits to monitor and
influence banks (Rey and Stiglitz 1993). As a result interest rate increases can lead to
substantial reductions in bank net worth, further exacerbating the banking crisis.19
Empirical studies by IMF and World Bank economists have confirmed that interest rate
rises tend to increase the probability of banking crises and that currency devaluations

18
Supporters of these policies, while recognizing these problems argue, that a temporary increase in
interest rates is required to restore confidence and that as long as the interest rate measures are very short-
term, little damage will be done. Whether increases in interest rates will, or should, restore confidence has
been much debated. The evidence from the recent experience is not fully supportive. Thailand and
Indonesia have been pursuing high-interest rate policies since summer 1997.
19
Most analyses of the U.S. saving and loan crisis place the ultimate blame on the unexpectedly large
increases in interest rates that began in the late 1970s under Fed Chairman Paul Volcker. This increase in
interest rates caused the value of their assets to plunge, leaving many with low or negative net worth.
Attempts to allow individual savings and loans to try to solve their own problems (part of regulatory
forbearance) failed, worsening the eventual debacle.

15
have no significant effect (Demirgüç-Kunt and Detragiache 1997).20
Advocates of high-interest rate policies have asserted that such policies are
necessary to restore confidence in the economy and thus stop the erosion of the
currency’s value. Halting the erosion of the currency, in turn, is important to both restore
the underlying strength of the economy and prevent a burst of inflation from the rise of
the price of imported goods.21 This prescription is based on assumptions about market
reactions— i.e. what will restore confidence— and economic fundamentals.
Ultimately confidence and economic fundamentals are inextricably intertwined.
Are measures that weaken of the economy, especially the financial system, likely to
restore confidence? To be sure, if an economy is initially facing high levels of inflation
caused by high levels of excess aggregate demand, increases in the interest rate will be
seen to strengthen the economic fundamentals by restoring macro-stability. For an
economy where there is little initial evidence of macro-imbalances but a predicted large
exogenous fall in aggregate demand, high interest rates will lead to an economic slump
and the slump will combine with the interest rates themselves to undermine the financial
system.

Fostering Competition

So far I have argued that macroeconomic policy needs to be expanded beyond a single-
minded focus on inflation and budget deficits; the set of policies that underlay the
Washington consensus are not sufficient for macroeconomic stability or long-term
development. Macroeconomic stability and long-term development require sound
financial markets. But the agenda for creating sound financial markets should not

20
There is another reason that government should perhaps be more sensitive to interest rate changes than to
exchange rate changes: while there is an economic logic to maturity mismatches, there is no corresponding
justification for exchange rate mismatches. There is a real cost associated with forcing firms to reduce
maturity mismatches. Exchange rate mismatches, in contrast, simply represent speculative behavior. In
practice, policy cannot rely on these general nostrums but needs to look carefully at the situation within the
country in crisis. It is possible that currency mismatches are far larger than maturity mismatches, and while
future actions might be directed at correcting such speculation with its systemic effects, current policy must
deal with the realities of today.
21
The persistence of the inflationary effects of a devaluation raise subtle questions. Earlier I argued against
the “precipice” theory of inflation. One might argue that an increase in the price level associated with a
devaluation is even less likely to give rise to inflation inertia than other sources of increases in prices,

16
confuse means with ends; redesigning the regulatory system, not financial liberalization,
should be the issue.
I now want to argue that competition is central to the success of a market
economy. Here, too, there has been some confusion between means and ends. Policies
that should have been viewed as means to achieve a more competitive marketplace were
seen as ends in themselves. As a result, in some instances they failed to attain their
objectives.
The fundamental theorems of welfare economics, the results that establish the
efficiency of a market economy, assume that both private property and competitive
markets exist in the economy. Many countries— especially developing and transition
economies— lack both. Until recently, however, emphasis was placed almost exclusively
on creating private property and liberalizing trade— trade liberalization being confused
with establishing competitive markets. Trade liberalization is important, but we are
unlikely to realize the full benefits of liberalizing trade without creating a competitive
economy.

Promoting free trade. Trade liberalization, leading eventually to free trade, was a
key part of the Washington consensus. The emphasis on trade liberalization was natural:
the Latin American countries had stagnated behind protectionist barriers.22 Import
substitution proved a highly ineffective strategy for development. In many countries
industries were producing products with negative value added, and innovation was
stifled. The usual argument— that protectionism itself stifled innovation— was somewhat
confused. Governments could have created competition among domestic firms, which
would have provided incentives to import new technology. It was the failure to create
competition internally, more than protection from abroad, that was the cause of the
stagnation. Of course, competition from abroad would have provided an important
source of competition. But it is possible that in the one-sided race, domestic firms would
have dropped out of the competition rather than enter the fray. Consumers might have
benefited, but the effects on growth may have been more ambiguous.

particularly when there may be a perception that the exchange rate has overshot.
22
Advocates of import substitution point out that during certain periods countries that pursued protectionist

17
 Trade liberalization may create competition, but it does not do so automatically.
If trade liberalization occurs in an economy with a monopoly importer, the rents may
simply be transferred from the government to the monopolist, with little decrease in
prices. Trade liberalization is thus neither necessary nor sufficient for creating a
competitive and innovative economy.
At least as important as creating competition in the previously sheltered import-
competing sector of the economy is promoting competition on the export side. The
success of the East Asian economies is a powerful example of this point. By allowing
each country to take advantage of its comparative advantage, trade increases wages and
expands consumption opportunities. For the past 15 years trade has been doing just
that— with world trade growing at 5 percent a year, nearly twice the rate of world GDP
growth.
Interestingly, the process by which trade liberalization leads to enhanced
productivity is not fully understood. The standard Hecksher-Ohlin theory predicts that
countries will shift intersectorally, moving along their production possibility frontier,
producing more of what they are better at and trading for what they are worse at. In
reality, the main gains from trade seem to come intertemporally, from an outward shift in
the production possibility frontier as a result of increased efficiency, with little sectoral
shift. Understanding the causes of this improvement in efficiency requires an
understanding of the links between trade, competition, and liberalization. This is an area
that needs to be pursued further.23

Facilitating privatization. State monopolies in certain industries have stifled

competition. But the emphasis on privatization over the past decade has stemmed less
from concern over lack of competition than from a focus on profit incentives. In a sense,
it was natural for the Washington consensus to focus more on privatization than on
competition. Not only were state enterprises inefficient, their losses contributed to the
government’s budget deficit, adding to macroeconomic instability. Privatization would

policies, notably Brazil and Taiwan (China) in the 1950s, did achieve strong economic growth.
23
The adverse effects associated with protectionism may come more from its impact on competition and
its inducement to rent-seeking behavior. These forces are so strong that even when there might be
seemingly strong arguments for trade interventions in particular cases, most economists view intervention

18
kill two birds with one stone, simultaneously improving economic efficiency and
reducing fiscal deficits.24 The idea was that if property rights could be created, the profit-
maximizing behavior of the owners would eliminate waste and inefficiency. At the same
time the sale of the enterprises would raise much needed revenue.
Although in retrospect the process of privatization in the transition economies
was, in several instances at least, badly flawed, at the time it seemed reasonable to many.
Although most people would have preferred a more orderly restructuring and the
establishment of an effective legal structure (covering contracts, bankruptcy, corporate
governance, and competition) prior to or at least simultaneous to promulgations, no one
knew how long the reform window would stay open. At the time privatizing quickly and
comprehensively— and then fixing the problems later on— seemed a reasonable gamble.
From today’s vantage point, the advocates of privatization may have overestimated the
benefits of privatization and underestimated the costs, particularly the political costs of
the process itself and the impediments it has posed to further reform. Taking that same
gamble today, with the benefit of seven more years of experience, would be much less
justified.
Even at the time many of us warned against hastily privatizing without creating
the needed institutional infrastructure, including competitive markets and regulatory
bodies. David Sappington and I showed in the fundamental theorem on privatization that
the conditions under which privatization can achieve the public objectives of efficiency
and equity are very limited and are very similar to the conditions under which
competitive markets attain Pareto-efficient outcomes (Sappington and Stiglitz 1987). If,
for instance, competition is lacking, creating a private, unregulated monopoly will likely
result in even higher prices for consumers. And there is some evidence that, insulated
from competition, private monopolies may suffer from several forms of inefficiency and
may not be highly innovative.
Indeed, both large-scale public and private enterprises share many similarities and

in trade policy with considerable skepticism.

24
Short-term impacts on deficits were, however, often markedly different from the long-term impacts. In
those cases where the state enterprises were reasonably well run, the latter could be negligible or even
negative while the former could be substantial. In response, some governments disallowed the inclusion of
capital transactions in the annual budget— an accounting practice consistent with views that such public
sector financial reorganization may have little impact on macro-behavior, or at least far different effects.

19
face many of the same organizational challenges (Stiglitz 1989). Both involve substantial
delegation of responsibility— neither legislatures nor shareholders in large companies
directly control the daily activities of an enterprise. In both cases the hierarchy of
authority terminates in managers who typically have a great deal of autonomy and
discretion. Rent seeking occurs in private enterprises, just as it does in public enterprises.
Shleifer and Vishny (1989) and Edlin and Stiglitz (1995) have shown that there are strong
incentives not only for private rent seeking on the part of management but for taking
actions that increase the scope for such rent seeking. In the Czech Republic the bold
experiment with voucher privatization seems to have foundered on these issues, as well
as the broader issues of whether, without the appropriate legal and institutional structures,
capital markets can provide the necessary discipline to managers as well as allocate
scarce capital efficiently.
Public organizations typically do not provide effective incentives and often
impose a variety of additional constraints. When these problems are effectively
addressed, when state enterprises are embedded in a competitive performance-based
environment, performance differences may narrow (Caves and Christenson, 1980).
The differences between public and private enterprises are blurry, and there is a
continuum of arrangements in between. Corporatization, for instance, maintains
government ownership but moves firms toward hard budget constraints and self-
financing; performance-based government organizations use output-oriented performance
measures as a basis for incentives. Some evidence suggests that much of the gains from
privatization occur before privatization as a result of the process of putting in place
effective individual and organizational incentives (Pannier 1996).
The importance of competition rather than ownership has been most vividly
demonstrated by the experience of China and the Russian Federation. China extended the
scope of competition without privatizing state-owned enterprises. To be sure, a number
of problems remain in the state-owned sector, which may be addressed in the next stage
of reform. In contrast, Russia has privatized a large fraction of its economy without
doing much to promote competition. The contrast in performance could not be greater,
with Russia’s output below the level attained almost a decade ago, while China has
managed to sustain double-digit growth for almost two decades. Though the differences

20
in performance may be only partially explained by differences in the policies they have
pursued, both the Chinese and Russian experiences pose quandaries for traditional
economic theories.
In particular, the magnitude and duration of Russia’s downturn is itself somewhat
of a puzzle: the Soviet economy was widely considered rife with inefficiencies, and a
substantial fraction of its output was devoted to military expenditures. The elimination of
these inefficiencies should have raised GDP, and the reduction in military expenditures
should have increased personal consumption still farther.25 Yet neither seems to have
occurred.
The magnitude and success of China’s economy over the past two decades also
represents a puzzle for standard theory. Chinese policymakers not only eschewed a
strategy of outright privatization, they also failed to incorporate numerous other elements
of the Washington consensus. Yet China’s recent experience is one of the greatest
economic success stories in history. If China’s 30 provinces were treated as separate
economies— and many of them have populations exceeding those of most other low-
income countries— the 20 fastest-growing economies between 1978 and 1995 would all
have been Chinese provinces (World Bank 1997a). Although China’s GDP in 1978
represented only about one-quarter of the aggregate GDP of low-income countries and its
population represented only 40 percent of the total, almost two-thirds of aggregate
growth in low-income countries between 1978 and 1995 was accounted for by the
increase in China’s GDP.
While measurement problems make it difficult to make comparisons between
Russia and China with any precision, the broad picture remains persuasive: real incomes
and consumption have fallen in the former Soviet Union, and real incomes and
consumption have risen rapidly in China.
One of the important lessons of the contrast between China and Russia is for the
political economy of privatization and competition. It has proved difficult to prevent
corruption and other problems in privatizing monopolies. The huge rents created by
privatization will encourage entrepreneurs to try to secure privatized enterprises rather

25
This can be thought of either as a movement toward the production possibilities curve or as an outward
shift of the production possibilities curve (a “technological improvement,” where the curve has embedded

21
than invest in creating their own firms. In contrast, competition policy often undermines
rents and creates incentives for wealth creation. The sequencing of privatization and
regulation is also very important. Privatizing a monopoly can create a powerful
entrenched interest that undermines the possibility of regulation or competition in the
future.
The Washington consensus is right— privatization is important. The government
needs to devote its scarce resources to areas the private sector does not and is not likely to
enter. It makes no sense for the government to be running steel mills. But there are
critical issues about both the sequencing and the scope of privatization. Even when
privatization increases productive efficiency, it may be difficult to ensure that broader
public objectives are attained, even with regulation. Should prisons, social services, or
the making of atomic bombs (or the central ingredient of atomic bombs, highly enriched
uranium) be privatized, as some in the United States have advocated? Where are the
boundaries? More private sector activity can be introduced into public activities (through
contracting, for example, and incentive-based mechanisms, such as auctions). How
effective are such mechanisms as substitutes for outright privatization? These issues
were not addressed by the Washington consensus.

Establishing regulation. Competition is an essential ingredient in a successful

market economy. But competition is not viable in some sectors— the so-called natural
monopolies. Even there, however, the extent and form of actual and potential
competition are constantly changing. New technologies have expanded the scope for
competition in many sectors that have historically been highly regulated, such as
telecommunications and electric power.
Traditional regulatory perspectives, with their rigid categories of regulation versus
deregulation and competition versus monopoly have not been helpful guides to policy in
these areas. These new technologies do not call for wholesale deregulation, because not
all parts of these industries are adequately competitive. Instead, they call for appropriate
changes in regulatory structure to meet the new challenges. Such changes must recognize
the existence of hybrid areas of the economy, parts of which are well suited to

in it the institutional constraints reflecting how production and distribution is organized).

22
competition, while other parts are more vulnerable to domination by a few producers.
Allowing a firm with market power in one part of a regulated industry to gain a
stranglehold over other parts of the industry will severely compromise economic
efficiency.

Forging competition policy. Although the scope of viable competition has

expanded, competition is often imperfect, especially in developing countries.
Competition is suppressed in a variety of ways, including implicit collusion and
predatory pricing. Control of the distribution system may effectively limit competition
even when there are many producers. Vertical restraints can restrict competition. And
new technologies have opened up new opportunities for anticompetitive behavior, as
recent cases in the U.S. airline and computer industry have revealed.
The establishment of effective antitrust laws for developing countries has not
been examined adequately. The sophisticated and complicated legal structures and
institutions in place in the United States may not be appropriate for many developing
countries, which may have to rely more on per se rules.
Competition policy also has important implications for trade policy. Currently,
most countries have separate rules governing domestic competition and international
competition (Australia and New Zealand are exceptions). With little if any justification,
rules governing competition in international trade (such as anti-dumping provisions and
countervailing duties) are substantially different from domestic antitrust laws (see Stiglitz
1997b); much of what we consider as healthy price competition domestically would be
classified as dumping.26 These abuses of fair trade were pioneered in the industrial
countries but are now spreading to the developing countries— which surpassed industrial
countries in the initiation of antidumping actions reported to the General Agreement on
Tariffs and Trade (GATT) and the World Trade Organization (WTO) for the first time in
1996 (World Bank 1997b). The best way to curtail these abuses would be to integrate
fair trade and fair competition laws based on the deep understanding of the nature of
competition that antitrust authorities and industrial organization economists have evolved

26
Lester Thurow has noted that, “if the [anti-dumping] law were applied to domestic firms, eighteen out of
the top twenty firms in Fortune 500 would have been found guilty of dumping in 1982.” (Thurow, 1985,

23
over the course of a century.

Government Acting as a Complement to Markets

For much of this century people have looked to government to spend more and intervene
more. Government spending as a share of GDP has grown with these demands (figure 6).
The Washington consensus policies were based on a rejection of the state’s activist role
and the promotion of a minimalist, noninterventionist state. The unspoken premise is that
governments are worse than markets. Therefore the smaller the state the better the state.
It is true that states are often involved in too many things, in an unfocused
manner. This lack of focus reduces efficiency; trying to get government better focused
on the fundamentals— economic policies, basic education, health, roads, law and order,
environmental protection— is a vital step. But focusing on the fundamentals is not a
recipe for minimalist government. The state has an important role to play in appropriate
regulation, social protection, and welfare. The choice should not be whether the state
should be involved but how it gets involved. Thus the central question should not be the
size of the government, but the activities and methods of the government. Countries with
successful economies have governments that are involved in a wide range of activities.
Over the past several decades, there has been an evolving framework within
which the issue of the role of the government can be addressed: the recognition that
markets might not always yield efficient outcomes— let alone socially acceptable
distributions— led to the market failures approach.27 There was a well-defined set of
market failures, associated with externalities and public goods, that justified government
intervention. This list of market failures was subsequently expanded to include imperfect
information and incomplete markets, but the market failure approach continued to focus
on dividing sectors and activities into those which should be in the government domain
and those that fall within the province of the private sector. More recently, there has been
a growing recognition that the government and private sector are much more intimately
entwined. The government should serve as a complement to markets, undertaking

p.359)
27
See Stiglitz (1989) for an extended discussion of the economic role of the state from this perspective.

24
actions that make markets work better and correcting market failures. In some cases the
government has proved to be an effective catalyst— its actions have helped solve the
problem of undersupply of (social) innovation, for example. But once it has performed
its catalytic role, the state needs to withdraw.28
I cannot review all of the areas in which government can serve as an important
complement to markets. I shall discuss briefly only two, building human capital and
transferring technology.

Building human capital. The role of human capital in economic growth has long been
appreciated. The returns to an additional year of education in the United States, for
instance, have been estimated at 5–15 percent (Willis, 1986; Kane and Rouse, 1995;
Ashenfelter and Krueger, 1994). The rate of return is even higher in developing
countries: 24 percent for primary education in Sub-Saharan Africa, for example, and an
average of 23 percent for primary education in all low-income countries (Psacharopoulos,
1994). Growth accounting also attributes a substantial portion of growth in developing
countries to human capital accumulation.29 The East Asian economies, for instance,
emphasized the role of government in providing universal education, which was a
necessary part of their transformation from agrarian to rapidly industrializing economies.
Left to itself, the market will tend to underprovide human capital. It is very
difficult to borrow against the prospects of future earnings since human capital cannot be
collateralized. These difficulties are especially severe for poorer families. The
government thus plays an important role in providing public education, making education
more affordable, and enhancing access to funding.

Transferring technology. Studies of the returns to research and development (R & D) in

industrial countries have consistently found individual returns of 20–30 percent and
social returns of 50 percent or higher— far exceeding the returns to education (Nadiri
1993). Growth accounting usually attributes the majority of per capita income growth to

28
The U.S. government, for example, established a national mortgage system, which lowered borrowing
costs and made mortgages available to millions of Americans. Having done so, however, it may be time
for this activity to be turned over to the private sector.
29
Mankiw, Romer, and Weil (1992).

25
improvements in total factor productivity— Solow’s (1957) pioneering analysis attributed
87.5 percent of the increase in output per man-hour between 1909 and 1949 to technical
change. Based on a standard Cobb-Douglas production function, per capita income in the
Republic of Korea in 1990 would have been only $2,041 (in 1985 international dollars) if
it had relied solely on capital accumulation, far lower than actual per capita income of
$6,665. The difference comes from increasing the amount of output per unit of input,
which is partly the result of improvements in technology.30
Left to itself, the market underprovides technology. Like investments in
education, investments in technology cannot be used as collateral. Investments in R & D
are also considerably riskier than other types of investment and there are much larger
asymmetries of information that can impede the effective workings of the market.31
Technology also has enormous positive externalities that the market does not reward.
Indeed, in some respects, knowledge is like a classical public good. The benefits to
society of increased investment in technology far outweigh the benefits to individual
entrepreneurs. As Thomas Jefferson said, ideas are like a candle, you can use them to
light other candles without diminishing the original flame. Without government action
there will be too little investment in the production and adoption of new technology.
For most countries not at the technological frontier, the returns associated with
facilitating the transfer of technology are much higher than the returns from undertaking
original research and development. Policies to facilitate the transfer of technology are
thus one of the keys to development. One aspect of these policies is investing in human
capital, especially in tertiary education. Funding of universities is justified not because it
increases the human capital of particular individuals but because of the major
externalities that come from enabling the economy to import ideas. Of course,
unemployment rates for university graduates are high in many developing countries, and
many university graduates hold unproductive civil service jobs. These countries have

30
While more recent studies (Young, 1994, for example) have questioned the robustness of these results
and some growth accounting exercises for the United States suggest little increase in total factor
productivity growth over the past quarter century, the observation that changes in technology have played a
major role in improvements in standards of living seems uncontroversial.
31
The innovator will be reluctant to describe his innovation to a provider of capital, lest he steal his idea;
but the provider of capital will be reluctant to supply capital without an adequate disclosure. A clear
regulatory structure for protecting intellectual property rights is necessary, but not sufficient, to overcome
these sorts of problems.

26
probably overemphasized liberal arts educations.32 In contrast, the Republic of Korea
and Taiwan (China) have narrowed the productivity gap with the leading industrial
countries by training scientists and engineers (figure 7).
Another policy that can promote the transfer of technology is foreign direct
investment. Singapore, for example, was able to assimilate rapidly the knowledge that
came from its large inflows of foreign direct investment.
Policies adopted by the technological leaders also matter. There can be a tension
between the incentives to produce knowledge and the benefits from more dissemination.
In recent years concern has been expressed that the balance industrial countries have
struck— often under pressure from special interest groups— underemphasizes
dissemination. The consequences may slow the overall pace of innovation and adversely
affect living standards in both richer and poorer countries.33

Making Government More Effective

How can policies be designed that increase the productivity of the economy? Again,
ends must not be confused with means. The elements stressed by the Washington
consensus may have been reasonable means for addressing the particular set of problems
confronting the Latin American economies in the 1980s, but they may not be the only, or
even the central, elements of policies aimed at addressing problems in other
circumstances.
Part of the strategy for a more productive economy is ascertaining the appropriate
role for government— identifying, for instance, the ways in which government can be a
more effective complement to markets. I now want to turn to another essential element
of public policy, namely, how we can make government more effective in accomplishing

32
There may also be an absence of complementary factors, such as the conditions required for new
enterprises to develop to use these skills.
33
Knowledge is a key input into the production of knowledge; an increase in the “price” of knowledge (as a
result of stricter intellectual property standards) may thereby reduce the production of knowledge. There is
also a concern that an excessive amount of expenditures on research are directed at trying to convert
“common knowledge” into a form that can be appropriated. While in principle “novelty” standards are
intended to guard against this, in practice the line is never perfectly clear, and stricter intellectual property
regimes are more likely to commit “errors” of privatizing public knowledge, thereby creating incentives for
misdirecting intellectual energies in that direction.

27
whatever tasks it undertakes.
World Development Report 1997 shows that an effective state is vital for
development (World Bank 1997c). Using data from 94 countries over three decades, the
study shows that it is not just economic policies and human capital but the quality of a
country’s institutions that determine economic outcomes. Those institutions in effect
determine the environment within which markets operate. A weak institutional
environment allows greater arbitrariness on the part of state agencies and public officials.
Given very different starting points— unique histories, cultures, and societal
factors— how can the state become effective? Part of the answer is that the state should
match its role to its capability. What the government does, and how it does it, should
reflect the capabilities of the government— and those of the private sector. Low-income
countries often have weaker markets and weaker government institutions. It is especially
important, therefore, that they focus on how they can most effectively complement
markets.
But capability is not destiny. States can improve their capabilities by
reinvigorating their institutions. This means not only building administrative or technical
capacity but instituting rules and norms that provide officials with incentives to act in the
collective interest while restraining arbitrary action and corruption. An independent
judiciary, institutional checks and balances through the separation of powers, and
effective watchdogs can all restrain arbitrary state action and corruption. Competitive
wages for civil servants can attract more talented people and increase professionalism and
integrity.
Perhaps some of the most promising and least explored ways to improve the
function of government is to use markets and market-like mechanisms. There are several
ways the government can do this:

(i) It can use auctions both for procuring goods and services and for allocating
public resources
(ii) It can contract out large portions of government activity
(iii) It can use performance contracting, even in those cases where contracting out
does not seem feasible or desirable

28
 (iv) It can design arrangements to make use of market information. For instance,
it can rely on market judgments of qualities for its procurement (off-the-shelf
procurement policies); it can use information from interest rates paid to, say,
subordinated bank debt to ascertain appropriate risk premiums for deposit
insurance

At the same time, governments are more effective when they respond to the needs
and interests of their citizens, while at the same time giving them a sense of ownership
and stake in the policies. Michael Bruno emphasized the importance of consensus
building in ending inflations. The reason for this should be obvious: if workers believe
that they are not being fairly treated, they may impose inflationary wage and other
demands, making the resolution of the inflationary pressures all but impossible (see
Bruno 1993).
At the microeconomic level, governments aid agencies and non-governmental
organizations have been experimenting with ways of providing decentralized support and
encouraging community participation in the selection, design, and implementation of
projects. Recent research provides preliminary support for this approach: a study by
Isham, Narayan and Pritchett (1995) found the success rate for rural water projects that
involved participation was substantially higher than the success rate for those that did not.
It is not just that localized information is brought to bear in a more effective way; but the
commitment to the project leads to the long-term support (or “ownership” in the popular
vernacular) which is required for sustainability.

29
Broadening the Goals of Development

The Washington consensus advocated use of a small set of instruments (including

macroeconomic stability, liberalized trade, and privatization) to achieve a relatively
narrow goal (economic growth). The post–Washington consensus recognizes both that a
broader set of instruments is necessary and that our goals are also much broader. We
seek increases in living standards— including improved health and education— not just
increases in measured GDP. We seek sustainable development, which includes
preserving natural resources and maintaining a healthy environment. We seek equitable
development, which ensures that all groups in society, not just those at the top, enjoy the
fruits of development. And we seek democratic development, in which citizens
participate in a variety of ways in making the decisions that affect their lives.
Knowledge has not kept pace with this proliferation of goals. We are only
beginning to understand the relationship between democratization, inequality,
environmental protection, and growth. What we do know holds out the promise of
developing complementary strategies that can move us toward meeting all of these
objectives. But we must recognize that not all policies will contribute to all objectives.
Many policies entail tradeoffs. It is important to recognize these tradeoffs and make
choices about priorities. Concentrating solely on “win-win” policies can lead
policymakers to ignore important decisions about “win-lose” policies.

Achieving Multiple Goals by Improving Education

Promoting human capital is one example of a policy that can help promote economic
development, equality, participation, and democracy. In East Asia universal education
created a more egalitarian society, facilitating the political stability that is a precondition
for successful long-term economic development. Education— especially education that
emphasizes critical, scientific thinking— can also help train citizens to participate more
effectively and more intelligently in public decisions.

30
Achieving Multiple Goals through Joint Implementation of Environmental Policy

To minimize global climate change, the nations of the world need to reduce the
production of greenhouse gasses, especially carbon dioxide, which is produced primarily
by combustion. The reduction of carbon emissions is truly a global problem. Unlike air
pollution (associated with sulfur dioxide or nitrogen dioxide), which primarily affects the
polluting country, all carbon emissions enter the atmosphere, producing global
consequences that affect the planet as a whole.
Joint implementation gives industrial countries (or companies within them) credit
for emissions reductions they would not otherwise have undertaken anywhere in the
world. It may be a feasible first step toward designing an efficient system of emission
reductions because it requires commitments only from industrial countries and therefore
does not entail resolving the huge distributional issues involved either in systems of
tradable permits or the undertaking of obligations by developing countries.
The premise of joint implementation is that the marginal cost of carbon reductions
may differ markedly in different countries. Because developing countries are typically
less energy efficient than industrial countries, the marginal cost of carbon reduction in
developing countries may be substantially lower than in industrial countries. The World
Bank has offered to set up a carbon investment fund that would allow countries and
companies that need to reduce emissions to invest in carbon-reducing projects in
developing countries. For developing countries this plan would offer increased
investment flows and pro-environment technology transfers. These projects would also
be likely to reduce the collateral environmental damage caused by dirty air. Joint
implementation allows industrial countries to reduce carbon emissions at a lower cost.
This strategy is designed to benefit the developing countries as it improves the global
environment.

Recognizing the Tradeoffs Involved in Investing in Technology

One important example of a potential tradeoff is investment in technology. Earlier I

discussed the way investments in tertiary technical education promote the transfer of

31
technology and thus economic growth. The direct beneficiaries of these investments,
however, are almost inevitably better off than average. The result is thus likely to be
increased inequality.
The transfer of technology may also increase inequality. Although some
innovations benefit the worst off, much technological progress raises the marginal
products of those who are already more productive. Even when it does not, the
opportunity cost of public investment in technology might be forgone investment in anti-
poverty programs. By increasing output, however, these investments can benefit the
entire society. The potential trickle down, however, is not necessarily rapid or
comprehensive.

Recognizing the Tradeoff between Protecting the Environment

and Increasing Participation

A second example of a tradeoff is the choice between environmental goals and

participation. Participation is essential. It is not, however, a substitute for expertise.
Studies have shown, for instance, that popular views on the ranking of various
environmental health risks are uncorrelated with the scientific evidence (United States
Environmental Protection Agency, 1987; Slovic, Layman, and Flynn, 1993). In pursuing
environmental policies, do we seek to make people feel better about their environment, or
do we seek to reduce real environmental health hazards? There is a delicate balance here,
but at the very least, more dissemination of knowledge can result in more effective
participation in formulating more effective policies.

32
Concluding Remarks

The goal of the Washington consensus was to provide a formula for creating a vibrant
private sector and stimulating economic growth. In retrospect the policy
recommendations were highly risk-averse— they were based on the desire to avoid the
worst disasters. Although the Washington consensus provided some of the foundations
for well-functioning markets, it was incomplete and sometimes even misleading.
The World Bank’s East Asian miracle project was a significant turning point in
the discussion. It showed that the stunning success of the East Asian economies
depended on much more than just macroeconomic stability or privatization. Without a
robust financial system— which the government plays a huge role in creating and
maintaining— it is difficult to mobilize savings or allocate capital efficiently. Unless the
economy is competitive, the benefits of free trade and privatization will be dissipated in
rent seeking, not directed toward wealth creation. And if public investment in human
capital and technology transfers is insufficient, the market will not fill the gap.
Many of these ideas— and more still that I have not had time to discuss— are the
basis of what I see as an emerging consensus, a post–Washington consensus consensus.
One principle that emerges from these ideas is that whatever the new consensus is, it
cannot be based on Washington. If policies are to be sustainable, developing countries
must claim ownership of them. It is relatively easier to monitor and set conditions for
inflation rates and current account balances. Doing the same for financial sector
regulation or competition policy is neither feasible nor desirable.
A second principle of the emerging consensus is that a greater degree of humility
is called for, acknowledgment of the fact that we do not have all of the answers.
Continued research and discussion, not just between the World Bank and the
International Monetary Fund but throughout the world, is essential if we are to better
understand how to achieve our many goals.

33
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 Table 1

Fiscal Costs of Banking Crises in

Selected Countries
(percentage of GDP)
Country (Date) Cost
(percentage of GDP)

Argentina (1980-82) 55.3

Chile (1981-83) 41.2
Uruguay (1981-84) 31.2
Isreal (1977-83) 30.0
Cote d’Ivoire (1988-91) 25.0
Senegal (1988-91) 17.0
Spain (1977-85) 16.8
Bulgaria (1990s) 14.0
Mexico (1995) 13.5
Hungary (1991-95) 10.0
Finland (1991-93) 8.0
Sweden (1991) 6.4
Sri Lanka (1989-93) 5.0
Malaysia (1985-88) 4.7
Norway (1987-89) 4.0
United States (1984-91) 3.2

Source: Caprio and Klingebiel 1996.

39
 Figure 1
Public Sector Deficits: Latin America versus East Asia
4
Surplus Latin America (1982) East Asia (1996)

2
Public sector deficit (percentage of GDP)

0
ile
il
ia

rea

es
ia

d
sia
a

ela
bia
az
in

an
liv

ys

in
Ch

ne

Ko
zu
nt

lom
Br

ail
ala

pp
Bo
ge

do
ne

Th
ili
M
Co
Ar

Ve

In

Ph
-1

-2

-3

-4

-5

Deficit

-6

Note: Calculations based on data from IMF International Financial Statistics Database. Figures for
Thailand are from 1995.
 Figure 2

Inflation: Latin America versus East Asia

600

Latin America
East Asia
500
Average inflation (GDP deflator)

400

300

200

100

0
1980 1982 1984 1986 1988 1990 1992 1994

Note: Unweighted regional averages based on World Development Indicators 1997 data.
 Figure 3

Inflation Rates in Developing Countries 1985,

1995
80
Percentage of developing countries

1985 1995
70

60

50

40

30

20

10

0
< 15 15-40 40-100 >100

Inflation rate (GDP deflator)

Source: World Development Indicators 1997.

Note: 121 of 158 low- and middle-income countries
 Figure 4

Volatility of GDP Growth, 1970-1995

Group median standard deviation of annual growth

6
(percent)

0
High Upper- Lower- Low Latin South East Asia Europe Middle Sub-
Income Middle Middle Income America Asia and East and Saharan
Income Income Central North Africa
Asia Africa

Source: Calculations based on real annual growth rates fromWorld Development Indicators 1997.
 Figure 5

GDP Growth before and after Banking Crises,

1975-94
3.5
Mean GDP growth (annual percent)

Five years before crisis

3
Five years after crisis
2.5

1.5

0.5

0
OECD crisis countries Non-OECD crisis countries Non-crisis countries

Source: Caprio 1997.

 Figure 6

Government Spending in Selected Countries

(as a percentage of GDP)
40

35 1960 1995

30
Percentage of GDP

25

20

15

10

Developing Thailand India Republic of Brazil (1961- Ethiopia Morocco

Country Korea 1993) (1964-1994) (1965-1992)
Average
Note: Data from IMF Government Financial Statistics.
 Figure 7

Tertiary Level Students in Technical Fields

(percentage of population)
0.9
Engineering
0.8
Natural Science, Math, and Computer
0.7 Science
Percent of population

0.6

0.5

0.4

0.3

0.2

0.1

0
Japan U.S. Hong Kong Singapore Republic of Taiwan (China)
Korea

Source: UNESCO, Statistical Yearbook 1995, Government of Taiwan, Taiwan Statistical Yearbook 1994, Ministry of
Education (Singapore)