Globalization and its Discontents:
By Joseph Stiglitz
Introduction
Globalization has been made possible by the closer integration of the countries and peoples of the world which
has been brought about by the enormous reduction of costs of transportation and communication, and the
breaking down of artificial barriers to the flow of goods, services, capital, knowledge, and (to a lesser extent)
people across borders. Globalization has been accompanied by the creation of new institutions that have joined
with existing ones to work across borders. It is powerfully driven by international corporations, which move not
only capital and goods across borders, but also technology. Globalization has also led to renewed attention to
long-established international intergovernmental institutions: the United Nations, which attempts to maintain
peace; the International Labor Organization (ILO), which promotes its agenda around the world under its slogan
‘decent work’; and the World Health Organization (WHO), which is concerned with improving health conditions in
the developing world.
Opening up to international trade has helped many countries grow far more quickly than they would have
otherwise. International trade helps economic development when a country’s exports drive its economic growth.
Export-led growth was the centerpiece of the industrial policy that enriched much of Asia and left millions of
people there better off. Because of globalization many people in the world now live longer than before and their
standard of living is far better. People in the West may regard low-paying jobs at Nike as exploitation, but for
many people in developing countries, working in a factory is a far better option than staying down on the farm and
growing rice. Globalization has also reduced the sense of isolation felt in much of the developing world and has
given many people in these countries access to knowledge well beyond the reach of even the wealthiest in any
country a century ago. New foreign firms may hurt protected state-owned enterprises but they can also lead to
the introduction of new technologies, access to new markets, and the creation of new industries.
It is the narrowly defined economic aspects of globalization that have been the subject of controversy, and the
international institutions that have written the rules, which mandate or push things like liberalization of capital
markets (the elimination of rules and regulations in many developing countries that are designed to stabilize the
flows of volatile money into and out of the country). To understand what has gone wrong, it’s important to look at
the three main institutions that govern globalization: the IMF, the World Bank, and the World Trade Organization
(WTO).
The International Monetary Fund, or IMF, is an organization that is in place to ensure financial stability in
countries around the world. It has the ability to provide massive funding to countries in crises, but it has also had
a habit of forcing its ideology on those countries in need. The IMF’s policies, in part based on the outworn
presumption that markets, by themselves, lead to efficient outcomes, have often failed to allow for desirable
government intervention in the market, measures which can guide economic growth and make everyone better
off. Inequality, unemployment and pollution are all examples of issues in which the government needs to take an
important role. Rarely has the IMF considered forecasts about what their policies would do to poverty. Rarely
have they partaken in thoughtful discussion and analysis of the consequences of alternative policies. They do
not seek alternatives and open, frank discussion is discouraged. There is but a single, one-size-fits-all,
prescription to all problems. Ideology guides IMF policy prescriptions and countries have been expected to follow
their guidelines without debate.
The IMF was founded on the belief that there was a need for collective action at the global level for economic
stability, just as the United Nations had been founded on the belief that there was a need for collective action at
the global level for political stability. The IMF is a public institution, established with money provided by taxpayers
around the world. This is important to remember because it does not report directly to either the citizens who
finance it or those whose lives it affects. Rather, it reports to the ministries of finance and the central banks of the
governments of the world. The major developed countries run the show, with only one country, the United States,
having effective veto. (In this sense, it is similar to the UN, where a historical anachronism determines who holds
the veto- the victorious powers of WW2- but at least there the veto power is shared among five countries).
The IMF has changed over the years. Founded on the belief that markets often worked badly, it now champions
market supremacy with ideological fervor. The most dramatic changes occurred during the 1980s, the era when
Ronald Reagan and Margaret Thatcher preached free market ideology in the US and the UK. The IMF and the
World Bank became the new missionary institutions, through which these ideas were pushed on the reluctant poor
countries that often badly needed their loans and grants.
This change in attitude to the free market mantra of the 1980s was part of a new ‘Washington Consensus’- a
consensus between the IMF, the World Bank, and the US Treasury about the ‘right’ policies for developing
countries- that signaled a radically different approach to economic development and stabilization. Capital market
liberalization has been pushed in spite of the fact that there is no evidence showing that it spurs economic
growth. In other cases, the economic policies that evolved into the Washington Consensus and were introduced
to developing countries were not appropriate for countries in the early stages of transition. This is in contrast to
the processes implemented by most of the advanced industrial countries- including the US and Japan- which had
built up their economies wisely and selectively protected some of their industries until they were strong enough to
compete with foreign companies.
Forcing a developing country to open itself up to imported products that would compete with those produced by
certain of its industries, industries that are dangerously vulnerable to competition from much stronger counterpart
industries in other countries, can have disastrous consequences- socially and economically. Jobs have
systematically been destroyed- poor farmers in developing countries simply couldn’t compete with the highly
subsidized goods from Europe and America- before the countries’ industrial and agricultural sectors were able to
grow strong and create new jobs. Even worse, the IMF’s insistence on developing countries maintaining tight
monetary policies has led to interest rates that would make job creation impossible even in the best of
circumstances. And because trade liberalization occurred before safety nets were put in place, those who lost
their jobs were forced into poverty.
Capital controls are another good example of the contrasts: European countries banned the free flow of capital
until the seventies. The influx of hot money into and out of a country that so frequently follows after capital market
liberalization leaves havoc in its wake, which has been demonstrated in the developing world.
Underlying the problems of the IMF and the other international economic institutions is the problem of
governance: who decides what they do. The institutions are dominated not just by the wealthiest industrial
countries but by commercial and financial interests in those countries, and the policies of the institutions naturally
reflect this. The IMF and the World Bank are led by representatives from the industrialized nations (By custom or
tacit agreement the head of the IMF is always a European, that of the World Bank an American). They are
chosen behind closed doors, and it has never even been viewed as a prerequisite that the head should have any
experience in the developing world. The institutions are not representative of the nations they serve.
The finance ministers and central bank governors typically are closely tied to the financial community; they come
from financial firms, and after their period of government service, that is where they return. These individuals
naturally see the world through the eyes of the financial community. The decisions of any institution naturally
reflect the perspectives and interests of those who make the decisions; not surprisingly, the policies of the
international economic institutions are all too often closely aligned with the commercial and financial interests of
those in the advanced industrial countries.
The World Bank and the IMF could have provided countries with alternative perspectives on some of the
challenges of development and transition, and in doing so they might have strengthened democratic processes.
But they were both driven by the collective will of the G-7 (the governments of the seven most important advanced
industrial countries), and especially their finance ministers and treasury secretaries, and too often, the last thing
they wanted was a lively democratic debate about alternative strategies.
The IMF is not particularly interested in hearing the thoughts of its ‘client countries’ on such topics as
development strategy or fiscal austerity. All too often, the Fund’s approach to developing countries has had the
feel of a colonial ruler. It considers itself the font of wisdom, the purveyor of an orthodoxy too subtle to be
grasped by those in the developing world. The message conveyed has been all too often clear: in the best of
cases there was an elite- a minister of finance or the head of a central bank- with whom the Fund might have a
meaningful dialogue. Outside this circle, there was little point in even trying to talk.
The IMF does not really claim expertise in development- its original mandate is supporting global economic
stability, not reducing poverty in developing countries- yet it does not hesitate to weigh in, and weigh in heavily,
on development issues. Development issues are complicated; in many ways, developing countries present far
greater difficulties than more developed countries. This is because in developing countries, markets are often
absent, and when present, often work imperfectly. Information problems abound, and cultural mores may
significantly affect economic behavior. Such policies are far more likely to succeed if crafted by highly educated,
first-rate economists already in the country, deeply knowledgeable about it and working daily on solving that
country's problems. Outsiders can play a role, in sharing the experiences of other countries, and in offering
alternative interpretations of the economic forces at play. But the IMF has not wanted to take on the mere role of
advisor, competing with others who might be offering their ideas. It has wanted a more central role in shaping
policy. And it could do this because its position was based on ideology- market fundamentalism- that required
little, if any, consideration of a country’s particular circumstances and immediate problems.
To illustrate this ideological approach, one needs only look at the standard IMF procedure before visiting a client
country, which is to write a draft report first. The visit is only intended to fine-tune the report and its
recommendations, and to catch any glaring mistakes. In practice, the draft report is often what is known as a
boilerplate, with whole paragraphs being borrowed from the report of one country and inserted into another.
Just as there has been a shift in the military balance of power in the world, there has been an even more dramatic
shift in the intellectual balance of power. The IMF is like so many bureaucracies; it has repeatedly sought to
extend what it does beyond the bounds of the objectives originally assigned to it. As the IMF’s mission creep
gradually brought it outside its core area of competency in macroeconomics, into structural issues, such as
privatization, labor markets, pension reforms, and so forth, and into broader areas of development strategies, the
intellectual balance of power became even more tilted. The IMF, of course, claims that it never dictates but
always negotiates the terms of any loan agreement with the borrowing country. But these are one-sided
negotiations in which all of the power is in the hands of the IMF, largely because many countries seeking IMF help
are in desperate need of funds.
Any announcement by the IMF that negotiations have been broken off, or even postponed, would send a highly
negative signal to the markets. This signal would at best lead to higher interest rates and at worst a total cutoff
from private funds. Even more serious for some of the poorest countries, which have in any case little access to
private funds, is that other donors (the World Bank, the European Union, and many other countries) make access
to their funds contingent on IMF approval. Recent initiatives for debt relief have given the IMF even more power,
because unless the IMF approves the country’s economic policy, there will be no debt relief. This gives the IMF
enormous leverage.
In dictating the terms of the agreements, the IMF effectively stifles any discussion within a client government- let
alone more broadly within the country- about alternative economic policies. In times of crises, the IMF would
defend its stance by saying there simply wasn’t time. But its behavior has been little different in or out of crises.
The IMF’s view has been simple: questions, particularly when raised vociferously and openly, would be viewed as
a challenge to the inviolate orthodoxy. If accepted, they might even undermine its authority and credibility. And if
the IMF was angry or annoyed, it could postpone its loans- a scary prospect for a country facing crisis. But the
fact that the government officials seem to go along with the IMF’s recommendations does not mean that they
really agree.
Countries were sometimes put on strict targets- what would be accomplished in 30 days, in 60 days, in 90 days.
In some cases the agreements stipulated what laws the country’s Parliament would have to pass to meet IMF
requirements or ‘targets’- and by when. Those requirements are referred to as ‘conditions’, and ‘conditionality’ is
a hotly debated topic in the development community. ‘Conditionality’ refers to more forceful conditions, ones that
often turn a loan into a policy tool. If the IMF wanted a nation to liberalize its financial markets, for instance, it
might pay out the loan in installments, tying subsequent installments to verifiable steps toward liberalization.
While conditionality did engender resentment, it did not succeed in engendering development. Studies at the
World Bank and elsewhere showed not just that conditionality did not ensure that money was well spent and that
countries would grow faster, but that there was little evidence that it worked at all. There are several reasons for
the failure of conditionality. Firstly, even if conditions are imposed which ensure that a particular loan is used well,
the loan frees up resources elsewhere, which may or may not be used well. In some cases, the wrong conditions
were imposed. In other cases, the way conditionality was imposed made the conditions politically unsustainable;
when a new government came into power, they would be abandoned. Such conditions were seen as an intrusion
by the new colonial power on the country’s own sovereignty. The policies could not withstand the vicissitudes of
the political process.
The IMF pushed privatization in part because it believed governments could not, in managing enterprises,
insulate themselves from political pressures. The very notion that the IMF could separate economics from politics,
or a broader understanding of society, illustrates a narrowness of perspective. If policies imposed by lenders
induce riots, as has happened in country after country, then economic conditions worsen, as capital flees and
businesses worry about investing more of their money. Such policies are not a recipe for successful development
or for economic stability.
IMF structural adjustment policies- the policies designed to help a country adjust to crises as well as to more
persistent imbalances- have led to hunger and riots in many countries; and even when results were not so dire,
even when the countries managed to eke out some growth for a while, often the benefits went disproportionately
to the better-off, with those at the bottom sometimes facing even greater poverty. Astoundingly, these policies
haven’t been questioned by many of the people in power in the IMF, by those who were making the critical
decisions. Both the IMF and the US Treasury are severely lacking in transparency, though they often require it of
the countries to which they provide aid. It is important, if we wish to see globalization succeed, that this changes.
There needs to be improvements in the information that citizens have about what the institutions do, allowing
those who are affected by the policies to have a greater say in their formulation.
The backlash against globalization draws its force not only from the perceived damage done to developing
countries by policies driven by ideology, but also from the inequities in the global trading system. Today, few-
apart from those with vested interests who benefit from keeping out the goods produced by the poor countries-
defend the hypocrisy of pretending to help developing countries by forcing them to open up their markets to the
goods of the advanced industrial nations while keeping their own markets protected, policies that make the rich
richer and the poor more impoverished- and increasingly angry.
A half century after its founding, it is clear that the IMF has failed in its mission. Worse, many of the policies that
the IMF pushed, in particular, premature capital market liberalization, have contributed to global instability. And
once a country was in crisis, IMF funds and programs not only failed to stabilize the situation but in many cases
actually made matters worse, especially for the poor.
Globalization itself is neither good nor bad. It has the power to do enormous good, and for the countries in East
Asia, who have embraced globalization under their own terms, at their own pace, it has been an enormous
benefit, in spite of the setback of the 1997 crisis. But in much of the world it has not brought comparable
benefits. For many, it seems closer to unmitigated disaster. Unfortunately, we have no world government,
accountable to the people of every country. We have a system of global governance without global government,
one in which a few institutions- the World Bank, the IMF, the WTO- and a few players- the finance, commerce, and
trade ministries, closely linked to certain financial and commercial interests- dominate the scene, but in which
many of those affected by their decisions are left almost voiceless. It’s time to change some of the rules
governing the international economic order, to think once again about how decisions get made at the international
level- and in whose interests- and to place less emphasis on ideology and to look more at what works.
We are a global community, and like all communities have to follow some rules so that we can live together.
These rules must be- and must be seen to be- fair and just, must pay due attention to the poor as well as the
powerful, must reflect a basic sense of decency and social justice. And in today’s world, those rules have to be
arrived at through democratic processes. There is an enormous cost to continuing global instability.
Globalization can be reshaped, and when it is, when it is properly, fairly run, with all countries having a voice in
policies affecting them, there is a possibility that it will create a new global economy in which growth is not only
more sustainable and less volatile but the fruits of this growth are more equitably shared.
Economics 101
It is clear that a crucial component in development is in the process undertaken to achieve it. This means
sequencing and pacing. Whenever information is imperfect and markets are incomplete, which is to say always,
particularly in developing countries, Adam Smith's 'invisible hand' works most imperfectly. The market system
requires clearly established property rights and the courts to enforce them; but often these are absent in
developing countries. The market system requires competition and perfect information. But competition is limited
and information is far from perfect- and well-functioning competitive markets cannot be established overnight.
The theory says that an efficient market economy requires that all of these assumptions be satisfied. In some
cases, reforms in one area, without accompanying reforms in others, may actually make matters worse. This is
the issue of sequencing. Ideology ignores these matters; it says simply move as quickly to the market system as
you can. But economic theory, not to mention history, shows how disastrous it can be to ignore sequencing.
There is a more fundamental criticism of the IMF/Washington Consensus approach: It does not acknowledge that
development requires a transformation of society. Part of the mantra today of development economics is a stress
on universal primary education, including educating girls. Countless studies have shown that countries, like those
in East Asia, which have invested in primary education, have done better. But in some very poor countries, such
as those in Africa, it has been very difficult to achieve high enrollment rates, especially for girls. The reason is
simple: poor families have barely enough to survive; they see very little direct benefit from educating their
daughters, and the education systems have been oriented towards enhancing employment opportunities mainly
through jobs in the urban sector considered more suitable for boys. Most countries, facing severe budgetary
constraints, have followed the Washington Consensus advice that fees should be charged. But in Uganda, for
example, President Museveni knew that he had to create a culture in which the expectation was that everyone
went to school. And he knew that he couldn't achieve this so long as fees were charged. So he ignored the
advice of the outside experts and simply abolished all school fees. Enrollments soared. As each family saw
others sending all of their children to school, it too decided to send its girls to school. This illustrates what the
simplistic statistical studies ignore: the power of systematic change.
The failures in many poor countries have set back the development agenda by unnecessarily corroding the very
fabric of society. It is inevitable that the process of development and rapid change puts enormous stresses on
society. Traditional authorities are challenged, traditional relationships are reassessed. That is why successful
development pays careful attention to social stability- a major lesson of Indonesia, where the IMF insisted on
abolishing subsidies for food and kerosene (the fuel used by the poor for cooking) just as IMF policies had
exacerbated the country’s recession, with incomes and wages falling and unemployment soaring. The riots that
ensued tore the country’s social fabric, exacerbating the ongoing depression. Abolishing the subsidies was not
only bad social policy; it was bad economic policy. These were not the first IMF-induced riots, and had the IMF
advice been followed more broadly, there surely would have been more. The IMF’s narrow economic view made it
impossible for it to consider these issues in their broader context.
Such riots are, however, like the tip of the iceberg: they bring to everyone’s attention the simple fact that the
social and political context cannot be ignored. Civil strife in Africa has been a major factor setting back its
development agenda. Studies at the World Bank show that such strife is systematically related to adverse
economic factors, including unemployment that can be produced by excessive austerity. Moderate inflation may
not be ideal for creating an environment for investment, but violence and civil strife are even worse. We must
recognize today that there is a ‘social contract’ that binds citizens together, and with their government. When
government policies abrogate that social contract, citizens may not honor their ‘contracts’ with each other, or with
the government. Maintaining that social contract is particularly important, and difficult, in the midst of social
upheavals that so frequently accompany the development transformation. The IMF has fought for what it
euphemistically calls ‘labor market flexibility’, which sounds like little more than making the labor market work
better, but as applied has been simply a code name for lower wages and less job protection. This does not
benefit stability in any way.
Part of the social contract entails ‘fairness’, that the poor share in the gains of society as it grows, and that the
rich share in the pains of society in times of crisis. The Washington Consensus believes in trickle-down
economics. Eventually, it is asserted, the benefits of growth trickle down even to the poor. Trickle-down
economics was never much more than just a belief, an article of faith. While it is true that sustained reductions in
poverty cannot be attained without robust economic growth, the converse is not true: growth need not benefit all.
It is not true that ‘a rising tide lifts all boats’. Sometimes, a quickly rising tide, especially when accompanied by a
storm, dashes weaker boats against the shore, smashing them to smithereens.
Because the governments of the East Asian countries- South Korea, China, Taiwan, Japan- did not believe that
growth would automatically benefit the poor, and because they believed that greater equality would actually
enhance growth, they took active steps to ensure that the rising tide of growth did lift most boats, that wage
inequalities were kept in bounds, that some educational opportunity was extended to all. Their policies led to
social and political stability, which in turn contributed to an economic environment in which businesses flourished.
Tapping new reservoirs of talent provided the energy and human skills that contributed to the dynamism of the
region. In Latin America, growth has not been accompanied by a reduction in inequality, or even a reduction in
poverty. In some cases, poverty has actually increased, as evidenced by the urban slums that dot the
landscape. The IMF talks with pride about the progress Latin America has made in market reforms over the past
decade, but has been eerily silent about the numbers in poverty.
It is important to look not only at what the IMF puts on its agenda, but also what it leaves off. Stabilization is on
the agenda; job creation is off. Taxation, and its adverse effects, is on the agenda; land reform is off. There is
money to bail out banks but not to pay for improved education and health services, let alone to bail out workers
who are thrown out of their jobs as a result of the IMF’s macroeconomic mismanagement.
Land reform, done properly, peacefully, and legally, ensuring that workers get not only land but access to credit,
and the extension services that teach them about new seeds and planting techniques, could provide an enormous
boost to output. But land reform represents a fundamental change in the structure of society, one that those in
the elite that populates the finance ministries, those with whom the international financial institutions interact, do
not necessarily like. Another neglected item on the IMF’s agenda is financial sector regulation. Crises around the
world have shown this to be a huge source of instability.
If land reform and financial sector regulation were underemphasized by the IMF and the Washington Consensus,
in many places inflation was overemphasized. An excessive focus on inflation by the IMF led to high interest rates
and high exchange rates, creating unemployment but not growth. Financial markets may have been pleased with
the low inflation numbers, but workers- and those concerned with poverty- were not happy with the low growth and
the high unemployment numbers.
Privatization often makes sense. Most countries would be better off with governments focusing on providing
essential public services rather than running enterprises that would arguably perform better in the private sector.
When trade liberalization- the lowering of tariffs and elimination of other protectionist measures- is done the right
way and at the right pace, so that new jobs are created as inefficient jobs are destroyed, there can be significant
efficiency gains. The problem was that many of these policies became ends in themselves rather than means to
more equitable and sustainable growth. In doing so, these policies were pushed too far, too fast, and to the
exclusion of other policies that were needed. The IMF vigorously pushed privatization and liberalization, at a pace
and in a manner that often imposed very real costs on countries ill-equipped to incur them.
There are some important preconditions that have to be satisfied before privatization can contribute to an
economy’s growth. And the way privatization is accomplished makes a great deal of difference. The IMF simply
assumes that markets arise quickly to meet every need, when in fact, many government activities arise because
markets have failed to provide essential services. Eliminating the government enterprise may leave a huge gap-
and even if eventually the private sector enters, there can be enormous suffering in the meantime.
The IMF argues that it is far more important to privatize quickly; dealing with issues of competition and regulation
later. But the danger here is that once a vested interest has been created, it has an incentive, and the money, to
maintain its monopoly position, squelching regulation and competition, and distorting the political process along
the way. There is a natural reason why the IMF has been less concerned about competition and regulation than it
might have been. Privatizing an unregulated monopoly can yield more revenue to the government, and the IMF
focuses far more on macroeconomic issues, such as the size of the government’s deficit, than on structural
issues, such as efficiency and competitiveness of the industry.
Another factor to consider is that privatization often turns state enterprises from losses to profits by trimming the
payroll. Economists, however, are supposed to focus on overall efficiency. There are social costs associated
with unemployment, which private firms simply do not take into consideration. Given minimal job protections,
employers can dismiss workers, with little or no costs, including, at best, minimal severance pay. In this way,
privatization often destroys jobs rather than creating new ones. There can be a large social cost- manifested, in
its worst forms, by urban violence, increased crime, and social and political unrest. But even in the absence of
these problems, there are huge costs to unemployment. They include wide-spread anxiety even among workers
who have managed to keep their jobs, a broader sense of alienation, additional financial burdens on family
members who manage to remain employed, and the withdrawal of children from school to help support the family.
These kinds of social costs endure long past the immediate loss of a job.
Domestic firms may at least be attuned to the social context and be reluctant to fire workers if they know there are
no alternative jobs available. Foreign owners, on the other hand, may feel a greater obligation to their
shareholders to maximize stock market value by reducing costs, and less of an obligation to what they refer to as
an ‘over-bloated labor force’.
The moral is a simple one: Privatization needs to be part of a more comprehensive program, which entails
creating jobs in tandem with the inevitable job destruction that privatization often entails. Macroeconomic policies,
including low interest rates, that help create jobs, have to be put in place. Timing (and sequencing) is everything.
Liberalization- the removal of government interference in financial markets, capital markets, and of barriers to
trade- has many dimensions. The one aspect of liberalization that does have wide-spread support- at least
among elites in the advanced industrial countries- is trade liberalization. Trade liberalization is supposed to
enhance a country’s income by forcing resources to move from less productive uses to more productive uses.
Unfortunately, it is easy to destroy jobs, and this is often the immediate impact of trade liberalization, as inefficient
industries close down under pressure from international competition. It takes capital and entrepreneurship to
create new firms and jobs, and in developing countries there is often a shortage of the latter, due to lack of
education, and of the former, due to lack of bank financing.
The most successful developing countries, those in East Asia, opened themselves to the outside world, but did so
slowly and in a sequenced way. These countries took advantage of globalization to expand their exports and
grew faster as a result. But they dropped protective barriers carefully and systematically, phasing them out only
when new jobs were created. They also ensured that there was capital available for new job and enterprise
creation; and they even took an entrepreneurial role in promoting new enterprises.
The hypocrisy of those pushing for trade liberalization- and the way they have pushed it- has no doubt reinforced
hostility towards it. The Western countries pushed trade liberalization for the products that they exported, but at
the same time continued to protect those sectors in which competition from developing countries might have
threatened their economies. Trade negotiations had lowered barriers on industrial goods, from automobiles to
machinery, exported by the advanced industrial countries. At the same time, negotiators for these countries
maintained their nations’ subsidies on agricultural goods and kept closed their markets for these goods and for
textiles, where many developing countries might have been able to get a toehold. One World Bank calculation
showed that Sub-Saharan Africa, the poorest region in the world, saw its income decline by more than 2 percent
as a result of the trade agreement.
Developing countries get especially angry over this sort of double standard because of a long history of hypocrisy
and inequities. In the nineteenth century the Western powers- many of which had grown through using
protectionist policies- had pushed unfair trade treaties. Today, the emerging markets are not forced open under
threat of military might, but through economic power, through the threat of sanctions or the withholding of needed
assistance in a time of crisis. Matters are perhaps worse still when the United States acts unilaterally rather than
behind the cloak of the IMF. The US Trade Representative or the Department of Commerce, often prodded by
special interests within the US, brings an accusation against a foreign country, which leads to a review process-
involving only the US government- with a decision made by the US, after which sanctions are brought against the
offending country. The US sets itself up as prosecutor, judge, and jury. The rhetoric the US uses to push its
position adds to the image of a superpower willing to throw its weight around for its own interests. What is
particularly disturbing is how special interests can undermine both US credibility and broader national interests.
The ill will that results is far out of proportion to any possible gain for the US. The process itself does little to
reinforce confidence in a just international trading system.
The American demand for liberalization of financial markets in China, for example, would not help secure global
economic stability. It was made to serve the narrow interests of the financial community in the US, which Treasury
vigorously represents. Wall Street believed, and rightly so, that China represented a potential vast market for its
financial services, and it was important that Wall Street get in, establish a strong toehold, before others could.
Hurrying the process up a year or two can surely make little difference, except that Wall Street worries that its
competitive advantage may disappear over time, as financial institutions from Europe and elsewhere catch up to
the short-term advantages of their Wall Street competitors. But the potential cost was enormous. In the
immediate aftermath of the Asian financial crisis, it was impossible for China to accede to Treasury’s demands.
For China, maintaining stability was essential; it could not risk policies that had proven so destabilizing elsewhere.
Zhu Rongji was forced to return to China without a signed agreement. As it turned out, Zhu Rongji and the reform
movement for which he stood were discredited, and the reformists’ power and influence were curtailed.
Fortunately, the damage was only temporary, but still, the US Treasury had shown how much it was willing to risk
to pursue its special agenda.
Even though unfair trade agendas were pushed, at least there exists considerable evidence that if implemented
properly they can have positive benefits. Financial market liberalization, on the other hand, is more problematic.
Many countries do have financial regulations that serve little purpose other than to impede the flow of capital and
should be stripped away. But all countries regulate their financial markets, and excessive zeal in deregulation has
brought on massive problems in capital markets even in developed countries around the world. The
consequences- economic recession- of banking crises brought on by capital market deregulation, while painful for
developed countries, are more serious for developing countries. The poor countries have no safety net to soften
the impact of recession. In addition, the limited competition in financial markets means that liberalization does not
always bring the promised benefits of lower interest rates. Instead, farmers have sometimes found that they had
to pay higher interest rates, making it more difficult for them to buy the seed and fertilizer necessary to eke out
their bare subsistence living.
Capital market liberalization entails stripping away the regulations intended to control the flow of hot money in and
out of a country- short-term loans and contracts that are usually no more than bets on exchange rate
movements. This speculative money cannot be used to build factories or create jobs- companies don’t make long-
term investments using money that can be pulled out on a moment’s notice- and indeed, the risk that such hot
money brings with it makes long-term investments in a developing country even less attractive. The adverse
affects on growth are even greater. To manage the risks associated with these volatile capital flows, countries
are routinely advised to set aside in their reserves an amount equal to there short-term foreign-denominated
loans.
To see what this implies, assume that a firm in a small developing country accepts a short-term $100 million loan
from an American bank, paying 18 percent interest. Prudential policy on the part of the country would require that
it add $100 million to its reserves. Typically reserves are held in US Treasury bills, which today pay around 4
percent. In effect, the country is simultaneously borrowing from the US at 18 percent and lending to the US at 4
percent. The country as a whole has no more resources available for investing. American banks make a tidy
profit and the US as a whole gains $14 million a year in interest. But it is hard to see how this allows a developing
country to grow faster. Put this way, it clearly makes no sense. There is a further problem: a mismatch of
incentives. With capital market liberalization, it is firms in a country’s private sector that get to decide whether to
borrow short-term funds from the American banks, but it is the government that must accommodate itself, adding
to its reserves if it wishes to maintain its prudential standing. One fact remains clear: instability is not only bad for
economic growth, but the costs of the instability are disproportionately borne by the poor.
It is important to remember that foreign investment creates growth. Foreign business brings with it technical
expertise and access to foreign markets, creating new employment possibilities. Foreign companies also have
access to sources of finance, especially important in those developing countries where financial institutions are
weak. Foreign direct investment has played an important role in many- but not all- of the most successful
development stories in countries such as Singapore and Malaysia and even China.
When foreign businesses come in they often destroy local competitors, quashing the ambition of the small
businessmen who had hoped to develop homegrown industry. One way to think about it is to recall the
controversy in the United States over the large chains of drugstores and convenience stores. When Wal-Mart
comes into a community, there are often strong protests by local firms, who fear (rightly) that they will be
displaced. Local shopkeepers worry they won’t be able to compete against Wal-Mart’s enormous buying power.
People living in small towns worry about what will happen to the character of the community if all the local stores
are destroyed. These same concerns are a thousand times stronger in developing countries. Although such
concerns are legitimate, one has to maintain perspective: the reason that Wal-Mart is so successful is that it
provides goods to consumers at lower prices. The more efficient delivery of goods and services to poor
individuals within developing countries is all the more important, given how close to subsistence so many live. It is
important to keep in mind though, that in the absence of strong (or effectively enforced) competition laws, after
the international firm drives out the local competition it uses its monopoly power to raise prices. The benefits of
low-prices were short-lived.
Banking is another area where foreign companies often overrun local ones. The large American banks can
provide greater security for depositors than do small local banks. The US government has been pushing for
opening up financial markets in developing nations. The advantages are clear: the increased competition can
lead to improved services. The greater financial strength of the foreign banks can enhance financial stability.
Still, the threat foreign banks pose to the local banking sector is very real.
Domestic banks are more sensitive to what used to be called 'window guidance'- subtle forms of influence by the
central bank, for example, to expand credit when the economy needs stimulus and contract it when there are
signs of overheating. Similarly, domestic banks are far more likely to be responsive to pressure to address basic
holes in the credit system- unserved or underserved groups, such as minorities and disadvantaged regions.
Argentina shows the dangers. There, before the collapse in 2001, the domestic banking industry had become
dominated by foreign-owned banks, and while the banks easily provide funds to multinationals, and even large
domestic firms, small and medium-size firms complained of a lack of access to capital. International banks’
expertise- and information base- lies in lending to traditional clients. Eventually, they may expand into these other
niches, or new financial institutions may arise to address these gaps, but the lack of growth- to which the lack of
finance contributed- was pivotal in Argentina’s collapse. Within Argentina, the problem was widely recognized; the
government took some limited steps to fill the credit gap. But government lending could not make up for the
market’s failure. So, the challenge must not just be to create sound banks, but also to create sound banks that
provide credit for growth.
There is also the issue of corruption associated with foreign direct investment. There have been instances where
new investors persuaded (often with bribes) governments to grant them special privileges, such as tariff
protection. In many cases, the US, French, or governments of other advanced industrial countries weighed in-
reinforcing the view within developing countries that it was perfectly appropriate for governments to meddle in and
presumably receive payments from the private sector. In some cases, the role of government seemed relatively
innocuous (although not necessarily uncorrupt), but in many cases, governments went well beyond the realm of
what was reasonable. In Argentina, the French government reportedly weighed in heavily pushing for a rewriting
of the terms of concessions for a water utility (Aguas Argentinas), after the French parent company (Suez
Lyonnaise) that had signed the agreements found them less profitable than they had thought.
Perhaps of greatest concern has been the role of governments in pushing nations to live up to agreements that
were vastly unfair to the developing countries, and often signed by corrupt governments in those countries.
There is, in fact, a long history of 'unfair' contracts, which Western governments have used their muscle to
enforce.
There is more to the list of legitimate complaints against foreign direct investment. Such investment often
flourishes only because of special privileges extracted from the government. While standard economics focuses
on the distortion of incentives that result from such privileges, there is a far more insidious aspect: often those
privileges are a result of corruption, the bribery of government officials. The foreign direct investment comes only
at the price of undermining democratic processes. This is particularly true for investments in mining, oil, and
other natural resources, where foreigners have a real incentive to obtain the concessions at low prices.
The income that mining concessions brings can be invaluable, but development is a transformation of society. An
investment in a mine- say in a remote region of a country- does little to assist the development transformation
beyond the resources that it generates. It can help create a dual economy, an economy in which there are
pockets of wealth. But a dual economy is not a developed economy. Indeed, the inflow of resources can
sometimes actually impede development. The inflow of capital leads to an appreciation of the currency, making
imports cheap and exports expensive. Worse still, the availability of resources can alter incentives: rather than
devoting energy to creating wealth, in many countries that are well-endowed with resources, efforts are directed
at appropriating the income (which economists refer to as 'rents') associated with the natural resources.
Though foreign direct investment can help development when used properly, it is not a necessary component to
development. Korea and Japan have had remarkable success in development with foreign investment playing no
role. In many cases, as in Singapore, China, and Malaysia, which kept the abuses of foreign direct investment in
check, foreign direct investment played a critical role, not so much for the capital (which, given the high savings
rate, was not really needed) or even for the entrepreneurship, but for the access to markets and new technology
that it brought along.
It is essential to recognize that there are many components that must be factored in together for development to
succeed. Trade liberalization accompanied by high interest rates is an almost certain recipe for job destruction
and unemployment creation- at the expense of the poor. Financial market liberalization unaccompanied by an
appropriate regulatory structure is an almost certain recipe for economic instability- and may well lead to higher,
not lower interest rates, making it harder for the poor farmers to buy the seeds and fertilizer that can raise them
above subsistence. Privatization unaccompanied by competition policies and oversight to ensure that monopoly
powers are not abused, can lead to higher, not lower, prices for consumers. Fiscal austerity, pursued blindly, in
the wrong circumstances, can lead to high unemployment and a shredding of the social contract.
The Washington Consensus reforms have exposed countries to greater risk, and the risks have been borne
disproportionately by those least able to cope with them. Just as in many countries the pacing and sequencing of
reforms has resulted in job destruction outmatching job creation, so too has the exposure to risk outmatched the
ability to create institutions for coping with risk, including effective safety nets.
The results of the policies enforced by the Washington Consensus have not been encouraging: for most
countries embracing its tenets development has been slow, and where growth has occurred, the benefits have not
been shared equally. Also, crises have been badly mismanaged. Inside the developing world, the questions run
deep. Those who have followed the prescriptions and endured the austerity are asking: When do we see the
fruits?
Broken Promises
Those who vilify globalization too often overlook its benefits. But the proponents of globalization have been, if
anything, even more unbalanced. To them, globalization is progress; developing countries must accept it, if they
are to grow and to fight poverty effectively. But to many in the developing world, globalization has not brought the
promised economic benefits. A growing divide between the haves and the have-nots has left increasing numbers
in the Third World in dire poverty, living on less than a dollar a day. Despite repeated promises of poverty
reduction made over the last decade of the twentieth century, the actual number of people living in poverty has
increased by almost 100 million. This occurred at the same time that total world income actually increased by an
average of 2.5 percent annually.
The West has driven the globalization agenda, ensuring that it garners a disproportionate share of the benefits,
at the expense of the developing world. The Western countries have pushed poor countries to eliminate trade
barriers, but kept up their own barriers, preventing developing countries from exporting their agricultural products
and so depriving them of desperately needed export income. The United States was, of course, one of the prime
culprits. This not only hurt the developing countries; it also cost Americans, both consumers, in the higher prices
they paid, and as taxpayers, to finance the huge subsidies, billions of dollars. Special commercial and financial
interests benefited greatly.
Western banks benefited from the loosening of capital market controls in Latin America and Asia, but those
regions suffered when inflows of speculative hot money (money that comes into and out of a country, often
overnight, often little more than betting on whether a currency is going to appreciate or depreciate) that had
poured into countries suddenly reversed. The abrupt outflow of money left behind collapsed currencies and
weakened banking systems.
Negotiations over the past decade have led to the strengthening of intellectual property rights. American and
other Western drug companies could now stop drug companies in India and Brazil from ‘stealing’ their intellectual
property. But these drug companies in the developing world were making these life-saving drugs available to
their citizens at a fraction of the price at which the drugs were sold by the Western drug companies. Thousands
were effectively condemned to death, because governments and people in the developing world could no longer
afford the high prices demanded. In the case of AIDS, the international outrage was so great that drug
companies had to back down, eventually agreeing to lower their prices, to sell the drugs at cost in late 2001.
When projects, whether agriculture or infrastructure, recommended by the West, designed with the advice of
Western advisors, and financed by the World Bank and others have failed, unless there is some form of debt
forgiveness, the poor people in the developing world still must repay the loans. If, in too many instances, the
benefits of globalization have been less than its advocates claim, the price paid has been greater, as the
environment has been destroyed, as political processes have been corrupted, and as the rapid pace of change
has not allowed countries time for cultural adaptation. These crises that have brought in their wake massive
unemployment, which in turn, has been followed by longer-term problems of social dissolution- from urban
violence in Latin America to ethnic conflicts in other parts of the world, such as Indonesia.
In Africa, the high aspirations following colonial independence have been largely unfulfilled. Instead, the continent
plunges deeper into misery, as incomes fall and standards of living decline. The hard-won improvements in life
expectancy gained in the past few decades have begun to reverse. While the scourge of AIDS is at the center of
this decline, poverty is also a killer. Even countries that have abandoned African socialism, managed to install
reasonably honest governments, balanced their budgets, and kept inflation down find that they simply cannot
attract private investors. Without this investment, they cannot have sustainable growth. And if globalization has
not succeeded in reducing poverty, neither has it succeeded in ensuring stability. For a while, in 1997 and 1998,
the Asian crises appeared to pose a threat to the entire world economy.
Globalization and the introduction of a market economy have not produced the promised results in Russia and
most of the other economies making the transition from communism to the market. These countries were told by
the West that the new economic system would bring them unprecedented prosperity. Instead, it has brought them
unprecedented poverty: in many respects, for most of the people, the market economy has proven even worse
than their Communist leaders had predicted. The contrast between Russia’s transition, as engineered by the
international economic institutions, and that of China, designed by itself, could not be greater: While in 1990
China’s GDP was 60 percent that of Russia, by the end of the decade the numbers had been reversed. While
Russia saw an unprecedented increase in poverty, China saw an unprecedented decrease.
For decades, the cries of the poor in Africa and in developing countries in other parts of the world have been
largely unheard in the West. Those who valued democratic processes saw how ‘conditionality’- the conditions
that international lenders imposed in return for their assistance- undermined national sovereignty. But until the
protestors came along there was little hope for change and no outlets for complaints. Some of the protestors
went to excesses; some of the protestors were arguing for higher protectionist barriers against the developing
countries, which would have made their plight even worse. But despite these problems, it is the trade unionists,
students, environmentalists- ordinary citizens- marching the streets of Prague, Seattle, Washington, and Genoa
who have put the need for reform on the agenda of the developed world.
For the peasants in the developing countries who toil to pay off their countries’ IMF debts or the businessmen who
suffer from higher value-added taxes upon the insistence of the IMF, the current system run by the IMF is one of
taxation without representation. Left with no alternatives, no way to express their concerns, to press for change,
people riot. Globalization as it has been practiced has not lived up to what its advocates promised it would
accomplish- or to what it can and should accomplish. In some cases it has not even resulted in growth, but when
it has, it has not brought the benefits to all; the net effect of the policies set by the Washington Consensus has all
too often been to benefit the few at the expense of the many, the well-off at the expense of the poor. In many
cases commercial interests and values have superseded concern for the environment, democracy, human rights,
and social justice.
The gap between the poor and the rich has been growing, and even the number in extreme poverty has
increased. There are 1.2 billion people around the world living on less than a dollar a day and 2.8 billion living on
less than $2 a day- more than 45 percent of the world's population. The unemployed are people, with families,
whose lives are affected- sometimes devastated- by the economic policies that outsiders recommend, and, in the
case of the IMF, effectively impose. Modern high-tech warfare is designed to remove physical contact: dropping
bombs from 50,000 feet ensures that one does not 'feel' what one does. Modern economic management is
similar: from one's luxury hotel, one can callously impose policies about which one would think twice if one knew
the people whose lives were being destroying.
Africa: Ethiopia and Botswana
In 1997, Prime Minister Meles was engaged in a heated dispute with the IMF, as the Fund had suspended its
lending program. Ethiopia's macroeconomic 'results'- upon which the Fund was supposed to focus- could not
have been better. There was no inflation; in fact, prices were falling. Output had been rising steadily since Meles
had ousted his predecessor Mengistu. Meles showed that, with the right policies in place, even a poor African
country could experience sustainable economic growth. After years of war and rebuilding, international
assistance was beginning to return to the country.
The IMF has a distinct role in international assistance. It is supposed to review each recipient's macroeconomic
situation and make sure that the country is living within its means. If it is not, there is inevitably trouble down the
road. In the short run, a country can live beyond its means by borrowing, but eventually a day of reckoning
comes and there is a crisis. The IMF is particularly concerned about inflation. Countries that spend more than
they take in taxes and foreign aid often will face inflation, especially if they finance their deficits by printing
money. Of course, there are other dimensions to good macroeconomic policy besides inflation, such as the
overall levels of growth and unemployment. A country can have low inflation but have no growth and high
unemployment. To most economists, inflation is not so much an end in itself, but a means to an end: it is because
excessively high inflation often leads to low growth, and low growth leads to high unemployment, that inflation is so
frowned upon. But the IMF often seems to confuse means with ends, thereby losing sight of what is ultimately of
concern.
If a country does not come up to certain minimum standards, the IMF suspends assistance; and typically, when it
does, so do other donors. Understandably, the IMF and the World Bank don't lend to countries unless they have
a good macroeconomic framework in place. Governments that fail to manage their overall economy generally do
a poor job managing foreign aid. But if the macroeconomic indicators- inflation and growth- are solid, as they
were in Ethiopia, surely the macroeconomic framework must be good. The World Bank also possessed direct
evidence of the competence of the government and its commitment to the poor. Surely, this was precisely the
kind of government to which the international community should have been giving assistance. But the IMF
suspended its program with Ethiopia, in spite of good macroeconomic performance, saying it worried about
Ethiopia's budgetary position.
The Ethiopian government had two revenue sources, taxes and foreign assistance. A government's budget is in
balance so long as its revenue sources equal its expenditures. Ethiopia, like many developing countries, derived
much of its revenue from foreign assistance. The IMF worried that if this aid dried up, Ethiopia would be in
trouble. Hence it argued that Ethiopia's budgetary position could only be judged solid if expenditures were limited
to the taxes it collected. The Fund contended that international assistance was too unstable to be relied upon, in
spite of the fact that assistance was often far more stable than tax revenues, which can vary markedly with
economic conditions.
But the IMF's reasoning was even more flawed. There are a number of appropriate responses to instability of
revenues, such as setting aside additional reserves and maintaining flexibility of expenditures. If revenues, from
any sourse, decline, and there are not reserves to draw upon, then the government has to be prepared to cut
back expenditures. But for the kinds of assistance that constitute so much of what a poor country like Ethiopia
receives, there is a built-in flexibility; if the country does not receive money to build an additional school, it simply
does not build the school. Ethiopia's officials understood what was at issue, they understood the concern about
what might happen if either tax revenues or foreign assistance should fall, and they had designed policies to deal
with these contingencies.
There was also an issue of a bank loan which Ethiopia had paid back to an American bank early, using some of
its reserves. The US and the IMF objected to the early repayment. They objected not to the logic of the strategy,
but to the fact that Ethiopia had undertaken this course of action without IMF approval. The IMF felt countries
receiving money from it had an obligation to report everything that might be germane; not to do so was grounds
for suspension of the program, regardless of the reasonableness of the action. To Ethiopia, such intrusiveness
smacked of a new form of colonialism; to the IMF, it was just standard operating procedure.
There were other sticking points in IMF-Ethiopia relations, concerning financial market liberalization. Ethiopia's
entire banking system is somewhat smaller than that of Bethesda, Maryland, a suburb on the outskirts of
Washington with a population of 55,000. The IMF wanted Ethiopia not only to open up its financial markets to
Western competition but also to divide its largest bank into several pieces. When global financial institutions
enter a country, they can squelch the domestic competition. And as they attract depositors away from the local
banks in a country like Ethiopia, they may be far more attentive and generous when it comes to making loans to
large multinational corporations than they will to providing credit to small businesses and farmers.
The IMF wanted to do more than just open up the banking system to foreign competition. It wanted to 'strengthen'
the financial system by creating an auction market for Ethiopia's government Treasury bills- a reform, as desirable
as it might be in many countries, which was completely out of tune with the country's state of development. It also
wanted Ethiopia to 'liberalize' its financial market, that is, allow interest rates to be freely determined by market
forces- something the US and Western Europe did not do until after 1970, when their markets, and the requisite
regulatory apparatus, were far more developed.
Ethiopia resisted the IMF's demand that it 'open' its banking system, for good reason. It had seen what happened
when one of its East African neighbors, Kenya, gave in to IMF demands. The results were disastrous: the move
was followed by the very rapid growth of local and indigenous commercial banks, at a time when banking
legislation and bank supervision were inadequate, with the predictable results- fourteen banking failures in Kenya
in 1993 and 1994 alone. In the end, interest rates increased, not decreased.
Faced with Ethiopian reluctance to accede to its demands, the IMF suggested the government was not serious
about reform and as stated earlier, suspended its program. Stiglitz and other economists at the World Bank were
able to persuade Bank management that lending more money to Ethiopia made good sense: it was a country
desperately in need, with a first-rate economic framework and a government committed to improving the plight of
its poor. World Bank lending tripled, even though it took months before the IMF finally relented on its position.
There are alternatives to IMF-style programs, other programs that may involve a reasonable level of sacrifice,
which are not based on market fundamentalism, programs that have had positive outcomes. A good example is
Botswana, 2,300 miles south of Ethiopia, a small country of 1.5 million, which has managed a stable democracy
since independence. It too was largely agricultural, lacked water, and had rudimentary infrastructure. But
Botswana is one of the success stories of development. Although the country is now suffering from the ravages
of AIDS, it averaged a growth rate of more than 7.5 percent from 1961 to 1997.
Botswana's success rested on its ability to maintain a political consensus, based on a broader sense of national
unity. That political consensus, necessary to any workable social contract between government and the
governed, had been carefully forged by the government, in collaboration with outside advisors, from a variety of
public institutions and private foundations, including the Ford Foundation. Unlike the IMF, which largely deals with
the finance ministry and the central banks, the advisors openly and candidly explained their policies as they
worked with the government to obtain popular support for the programs and policies with open seminars as well
as one-to-one meetings. Part of the reason for this success was that the senior people in Botswana's
government took great care in selecting their advisors.
The differences in how the two organizations approached development were reflected not just in performance.
While the IMF is vilified almost everywhere in the developing world, the warm relationship that was created
between Botswana and its advisors was symbolized by the awarding of that country's highest medal to Steve
Lewis, who at the time he advised Botswana was a professor of development economics at Williams.
The vital consensus was threatened two decades ago when Botswana had an economic crisis. Botswana,
recognizing the volatility of its two main sectors, cattle and diamonds, had prudently set aside reserve funds for
such a crisis. As it saw its reserves dwindling, it knew it would have to take further measures. Botswana tightened
its belt, pulled together, and got through the crisis. But because of the broad understanding of economic policies
that had been developed over the years and the consensus-based approach to policy making, the austerity did
not cause the kinds of cleavages in society that have occurred so frequently elsewhere under IMF programs.
Presumably, if the IMF had done what it should have been doing- providing funds quickly to countries with good
economic policies in times of crisis, without searching around for conditionalities to impose- the country would
have been able to get through the crisis with even less pain.
Ethiopia and Botswana are emblematic of the challenges facing the more successful countries in Africa today:
countries with leaders dedicated to the well-being of their people, fragile and in some cases imperfect
democracies, attempting to create new lives for their people from the wreckage of a colonial heritage that left
them without institutions or human resources.
East Asia Crisis
Not long before the crisis, even the IMF had forecast strong growth. Over the preceding three decades, East Asia
had not only grown faster and done better at reducing poverty than any other region of the world, developed or
less developed, but it had also been more stable. The IMF and the World Bank had almost consciously avoided
studying the region, though presumably because of its success, it would have seemed natural for them to turn to
it for lessons for others. Only under pressure from the Japanese had the World Bank undertaken the study of the
economic growth in East Asia and then only after the Japanese had offered to pay for it. The reason was
obvious: the countries had been successful not only in spite of the fact that they had not followed most of the
dictates of the Washington Consensus, but because they had not.
The combination of high savings rates, government investment in education, and state-directed industrial policy
all served to make the region an economic powerhouse. Growth rates were phenomenal for decades and the
standard of living rose enormously for tens of millions of people. The benefits of growth were shared widely. The
governments had devised a strategy that worked, a strategy that had but one item in common with the
Washington Consensus policies- the importance of macroeconomic stability. As in the Washington Consensus,
trade was important, but the emphasis was on promoting exports, not removing impediments to imports. Trade
was eventually liberalized, but only gradually, as new jobs were created in the export industries. While the
Washington Consensus policies emphasized rapid financial and capital market liberalization, the East Asian
countries liberalized only gradually- some of the most successful, like China, still have a long way to go. In the
Washington Consensus view, industrial policies, in which governments try to shape the future direction of the
economy, are a mistake. But the East Asian governments took that as one of their central responsibilities. In
particular, they believed that if they were to close the income gap between themselves and the more developed
countries, they had to close the knowledge and technological gap, so they designed education and investment
policies to do that.
This period of time saw international attention focus on newly emerging markets, from East Asia to Latin America,
and from Russia to India. Investors saw these countries as a paradise of high returns and seemingly low risk. In
the short space of seven years, private capital flows from the developed to the less developed countries
increased sevenfold while public flows (foreign aid) stayed steady. The IMF and the US Treasury believed, or at
least argued, that full capital account liberalization would help the region grow even faster. The countries in East
Asia had no need for additional capital, given their high savings rate, but still capital account liberalization was
pushed on these countries in the late eighties and early nineties.
IMF officials were so sure of their advice that they even asked for a change in its charter to allow it to put more
pressure on developing countries to liberalize their capital markets. Meanwhile, the leaders of the Asian countries
were terrified. They viewed the hot money that came with liberalized capital markets as the source of their
problems. They knew that major trouble was ahead: a crisis would wreak havoc on their economies and their
societies, and they feared that IMF policies would prevent them from taking the actions that they thought might
stave off the crisis, and that the policies the IMF would insist upon should a crisis occur would worsen the impacts
on their economy. They felt, however, powerless to resist. They even knew what could and should be done to
prevent a crisis and minimize the damage- but they knew the IMF would condemn them if they undertook those
actions and they feared the resulting withdrawl of international capital. In the end, only Malaysia was brave
enough to risk the wrath of the IMF; and though Prime Minister Mahathir’s policies- trying to keep interest rates
low, trying to put the brakes on the rapid flow of speculative money out of the country- were attacked from all
quarters, Malaysia’s downturn was shorter and shallower than that of any of the other countries.
The IMF has consistently pushed capital account liberalization even though there exists little evidence that it
promotes growth, and there exists ample evidence that it imposes a huge risk on developing countries. It has
become all too clear that capital account liberalization represents risk without reward. Even when countries have
strong banks, a mature stock market, and other institutions that many of the Asian countries did not have, it can
impose enormous risk. Surely, one might have argued, there must be some basis for the IMF’s position, beyond
serving the naked self-interest of financial markets, which saw capital account liberalization as just another form of
market access- more markets in which to make more money. Capital market liberalization made the developing
countries subject to both the rational and irrational whims of the investor community, to their irrational exuberance
and pessimism. Probably no country could have withstood the sudden change in investor sentiment, a sentiment
that reversed this huge inflow to a huge outflow as investors, both foreign and domestic, put their funds
elsewhere. Inevitably, such large reversals would precipitate a crisis, a recession, or worse. While developing
countries’ ability to withstand the reversal was weak, so too was their ability to cope with the consequences of a
major downturn. Their remarkable economic performance- no major economic recessions in three decades-
meant that East Asian countries had not developed unemployment insurance schemes. But even if they had
turned their mind to the task, it would not have been easy: in the US, unemployment insurance for those who are
self-employed in agriculture is far from adequate, and this is precisely the sector that dominates in the developing
world.
The crisis that began in 1997 with the collapse of the Thai baht was the greatest economic crisis since the Great
Depression. It spread from Asia to Russia and Latin America and threatened the entire world’s economy.
Currency speculation spread and hit Malaysia, Korea, the Philippines, and Indonesia, and by the end of the year
what had started as an exchange rate disaster threatened to take down many of the region’s banks, stock
markets, and even entire economies. The crisis is over now, but economies in places such as Indonesia will feel
its effects for years.
Since the IMF was founded precisely to avert and deal with crises of this kind, the fact that it failed in so many
ways led to a major rethinking of its role. Indeed, in retrospect, it became clear that the IMF policies not only
exacerbated the downturns but were partially responsible for the onset: excessively rapid financial and capital
market liberalization was probably the single most important cause of the crisis.
There are two familiar patterns to these crises. The first is illustrated by South Korea, a country with an
impressive track record. As it emerged from the wreckage of the Korean War, South Korea formulated a growth
strategy which increased per capita income eight-fold in thirty years, reduced poverty dramatically, achieved
universal literacy, and went far in closing the gap in technology between itself and the more advanced countries.
Through good products and aggressive marketing, South Korean companies had sold their goods around the
world. South Korea realized that continued growth would require some liberalization, or deregulation, in the way
it's financial and capital markets were run, but whereas in the early days of its transformation it had tightly
controlled its financial markets, under pressure from the United States it had reluctantly allowed its firms to borrow
abroad. Wall Street saw profitable opportunities and didn’t want to wait as South Korea’s carefully charted path
slowly developed. The Treasury Department pressured South Korea, not because liberalization was an issue of
US national interests, but specifically because it would help the special interests of Wall Street. Forcing Korea to
liberalize faster would not create many jobs in the US, nor would it lead to significant increases in American GDP.
It was not even clear that the US would, as a whole, even benefit, and it was clear that Korea might in fact be
worse off. It should be noted that US Treasury decisions are made behind closed doors with no transparency,
and it is quite unusual for its positions to be overridden. The US Treasury won and got what it wanted, South
Korea and the global economy lost. In borrowing abroad, the Korean firms exposed themselves to the vagaries of
the international market: in late 1997, rumors flashed through Wall Street that Korea was in trouble. It would not
be able to roll over loans from Western banks that were coming due, and it did not have the reserves to pay them
off. Such rumors can be self-fulfilling prophecies. Quickly, the banks which such a short time earlier had been so
eager to lend money to Korean firms decided not to roll over their loans. When they all decided not to roll over
their loans, their prophecy came true: Korea was in trouble.
The second was illustrated by Thailand. There, a speculative attack (combined with high short-term
indebtedness) was to blame. Speculators, believing that a currency will devalue, try to move out of the currency
and into dollars; with free convertibility- that is, the ability to change local currency for dollars or any other
currency- this can easily be done. But as traders sell the currency, its value is weakened- confirming their
prophecy. Alternatively, and more commonly, the government tries to support the currency. It sells dollars from
its reserves (money the country holds, often in dollars, against a rainy day), buying up the local currency, to
sustain its value. But eventually, the government runs out of hard currency. There are no more dollars to sell.
The currency plummets. The speculators are satisfied. They have bet right. They can move back into the
currency and make a nice profit. The magnitude of the returns can be enormous. As perceptions that
devaluation is imminent grow, the chance to make money becomes irresistible and speculators from around the
world pile in to take advantage of the situation.
Before liberalization, Thailand had severe limitations on the extent to which banks could lend for speculative real
estate. It had imposed these limits because it was a poor country that wanted to grow, and it believed that
investing the country’s scarce capital in manufacturing would both create jobs and enhance growth. It also knew
that throughout the world, speculative real estate lending is a major source of economic instability. This type of
lending gives rise to bubbles (the soaring of prices as investors clamor to reap the gain from the seeming boom in
the sector); these bubbles always burst; and when they do, the economy crashes. The pattern is familiar: as real
estate prices rise, banks feel they can lend more on the basis of collateral; as investors see prices going up, they
want to get in on the game before it is too late- and the bankers give them the money to do it. Real estate
developers see quick profits by putting up new buildings, until excess capital results. The developers can’t rent
their space, they default on their loans, and the bubble bursts. While Thailand was desperate for more public
investment to strengthen its infrastructure and relatively weak secondary and university education systems,
billions were squandered on commercial real estate. These buildings remain empty today, testimony to the risks
posed by excessive market exuberance and the pervasive market failures that can arise in the presence of
inadequate government regulation of financial institutions.
In response to these crises, the IMF provided huge amounts of money (the total bailout packages, including
money from the G-7 countries, was $95 billion) so that the countries could sustain the exchange rate. It thought
that if markets believed there was enough money in the coffers, there would be no point in attacking the currency,
and thus ‘confidence’ would be restored. The money served another function: it enabled the countries to provide
dollars to the firms that had borrowed from Western bankers to repay the loans. It was thus, in part, a bailout to
the international banks as much as it was a bailout to the country; the lenders did not have to face the full
consequences of having made bad loans. And in country after country in which the IMF money was used to
maintain the exchange rate temporarily at an unsustainable level, there was another consequence: rich people
inside the country took advantage of the opportunity to convert their money into dollars at the favorable exchange
rate and whisk it abroad. This phenomenon is sometimes given the more neutral sounding name of ‘capital
flight’. While the IMF had provided some $23 billion to be used to support the exchange rate and bail out
creditors, the far, far smaller sums required to help the poor were not forthcoming. In American parlance, there
were billions and billions for corporate welfare, but not the more modest millions for welfare for ordinary citizens.
The IMF combined this bailout money with conditions, in a package which was supposed to rectify the problems
that caused the crisis. The ingredients typically included higher interest rates- in the case of East Asia, much,
much higher interest rates- plus cutbacks in government spending and increases in taxes. They also included
‘structural reforms’, that is changes in the structure of the economy which, it is believed, lies behind the country’s
problems. The IMF would claim that imposing these conditions was the responsible thing to do. It was providing
billions of dollars; it had a responsibility to make sure not just that it was repaid but that the countries ‘did the right
thing’ to restore their economic health. The breadth of the conditions meant that countries accepting Fund aid
had to give up a large part of their economic sovereignty. Some of the objection to the IMF programs was based
on this, and the resulting undermining of democracy; and some were based on the fact that the conditions did not
(and arguably were not designed to) restore the economies’ health.
The programs- with all of their conditions and with all of their money- failed. In each case, embarrassed by the
failure of its supposed medicine to work, the IMF charged the country with failing to take the necessary reforms
seriously. In each case, it announced to the world that there were fundamental problems that had to be
addressed before true recovery could take place. Doing so was like crying fire in a crowded theatre: investors
more convinced by the diagnosis of the problems than by the prescriptions, fled. Rather than restoring
confidence that would lead to an inflow of capital into the country, IMF criticism exacerbated the stampede of
capital out. Indeed, in several of the crisis countries, ordinary people as well as many government officials and
business people continue to refer to the economic and social storm that hit their nations simply as “the IMF”- the
way one would say “the plague” or “the Great Depression.”
Probably the IMF mistake that is hardest to fathom was the Fund’s failure to recognize the important interactions
among the policies pursued in different countries. Contractionary policies in one country not only depressed that
country’s economy but had adverse effects on its neighbors. By continuing to advocate contractionary policies
the IMF exacerbated the contagion- the spread of the downturn from one country to the next. As each country
weakened, it reduced its imports from its neighbors, thereby pulling its neighbors down. Countries were told that
when facing a downturn they must cut back on their trade deficit, and even build a trade surplus. This might be
logical if the central objective of a country’s macroeconomic policy were to repay foreign creditors. By building up
a war chest of foreign currency, a country will be better able to pay its bills- never mind the cost to those inside
the country and elsewhere. Enormous pressure was put on countries not to increase tariffs or other trade
barriers in order to decrease imports, even if countries were facing a recession. The IMF also inveighed strongly
against further devaluation. With tariffs and devaluation ruled out, there were but two ways to build a trade
surplus. One was to increase exports; but this was not easy, and cannot be done quickly, particularly when the
economies of your major trading partners are weak and your own financial markets are in disarray, so exporters
can’t find finance to expand. The other was to reduce imports- by cutting incomes, that is, inducing a major
recession. Unfortunately for the countries, and the world, this was the only option left.
This is what happened in East Asia in the late 1990’s: contractionary fiscal and monetary policies combined with
misguided financial policies led to massive economic downturns, cutting incomes, which reduced imports and led
to huge trade surpluses, giving the countries the resources to pay back foreign creditors. As each country’s
imports were cut back, so to were other countries’ exports. As a result, all of these countries saw a reduction in
sales abroad. The downturn was exported around the region. Only this time, there was not even the saving
grace that as the downturn was exported, the domestic economy was strengthened. As the downturn spread
around the world, slower growth in the region led to a collapse in commodity prices, like oil, and the collapse in
those prices wrought havoc in oil-producing countries like Russia.
The IMF forced countries in East Asia to raise interest rates to astronomical levels, more than 25 percent. To put
this in perspective, it is considered a big deal when the Fed in the US raises interest rates by only ¼ of a
percentage point. The reasoning behind these policies was simple, if not simplistic. If a country raised interest
rates, it would make it more attractive for capital to flow into that country. Capital flows into the country would help
support the exchange rate and thus stabilize the currency. End of argument.
At first glance, this appears logical. The glaring omission though, is that it neglects the issue of bankruptcy. It
failed to analyze what increased interest rates would do to the chances of default and to the amount creditors can
recover in the event of default. Many of the firms were highly indebted, and had huge debt to equity ratios.
Indeed, the excessive leverage had repeatedly been cited as one of South Korea’s weaknesses, even by the
IMF. Highly leveraged companies are particularly sensitive to interest rate increases. At very high interest rate
levels, a highly leveraged company goes bankrupt quickly. Even if it does not go bankrupt, its equity (net worth)
is quickly depleted as it is forced to pay huge amounts to creditors. The consequences of the high interest rate
levels that the IMF pushed were precisely as should have been predicted: The high interest rates increased the
number of firms in distress, and thereby increased the number of banks facing nonperforming loans. This
weakened the banks further. The increased distress in the corporate and financial sectors exacerbated the
downturn that the contractionary policies were inducing through the reduction in aggregate demand. The IMF
had engineered a simultaneous contraction in aggregate demand and supply.
Local investors, just like international investors, were not interested in pouring money into an economy going into
a tailspin. Higher interest rates did not attract more capital into the country. On the contrary, the higher rates
made the recession worse and actually drove capital out of the country. In Thailand, for instance, it was the
already bankrupt real estate firms and those that lent to them who had the most foreign-denominated debt.
Further devaluation might have harmed the foreign creditors but would not have made these firms any more
dead. In effect, the IMF made the small businesses and other innocent bystanders pay for those who had
engaged in excessive dollar borrowing. In Indonesia, an estimated 75 percent of all businesses were put into
distress, while in Thailand close to 50 percent of bank loans became nonperforming. Unfortunately, it is far easier
to destroy a firm than to create a new one. Lowering interest rates would not un-bankrupt a firm that had been
forced into bankruptcy: its net worth would still have been wiped out. The IMF’s mistakes were thus slow to
reverse.
As the crisis worsened, the need for ‘restructuring’ became the new mantra. Banks that had bad loans on their
books should be shut down; companies that owed money should be closed or taken over by their creditors. The
IMF focused on this rather than simply performing the role it was supposed to fill: providing liquidity to finance
needed expenditures. Alas, even this focus on restructuring failed, and much of what the IMF did helped push the
sinking economies down further. If the financial system breaks down, firms cannot get the working capital they
need to continue existing levels of production, let alone finance expansion through new investment. A crisis can
give rise to a vicious circle wherein banks cut down on their finance, leading firms to cut back on their production,
which in turn leads to lower output and lower incomes. As output and incomes plummet, profits fall, and some
firms are even forced into bankruptcy. When firms declare bankruptcy, banks’ balance sheets become worse,
and the banks cut down lending even further, exacerbating the economic downturn.
If enough firms fail to repay their loans, banks may even collapse. A collapse of even a single large bank can
have disastrous consequences. Financial institutions determine creditworthiness. When a bank goes out of
business in good times, many of its customers will have difficulty finding an alternative supplier of credit
overnight. In developing countries, where sources of finance are even more limited, if the bank that a business
relies upon fails, finding a new source of funds- especially during an economic downturn- may be nearly
impossible. Fears of this vicious circle have induced governments throughout the world to strengthen their
financial systems through prudent regulation. Repeatedly, free marketeers have bridled against the regulations.
Thus, the IMF overlooked another critical lesson: the importance of keeping credit flowing. Its strategy for
financial restructuring made it so banks had to have a certain ratio of capital to their outstanding loans and other
assets; this ratio is termed the ‘capital adequacy ratio’. Not surprisingly, when many loans are nonperforming,
many banks fail to meet their capital adequacy ratio. The IMF insisted that banks either shut down or quickly
meet this ratio. But the insistence on banks quickly meeting capital adequacy standards exacerbated the
downturn. When only one bank has a problem, then insisting on it meeting its capital adequacy ratio makes
sense. But when many, or most, banks are in trouble, that policy can be disastrous. There are two ways of
increasing the ratio of capital to loans: increasing capital or decreasing loans. In the midst of a downturn,
particularly of the magnitude of that in East Asia, it is hard to raise new capital. The alternative is to reduce
outstanding loans. But as each bank calls in its loans, more and more firms are put into distress. Without
adequate working capital, they are forced to cut back on their production, cutting into the demand for products
from other firms. The downward spiral is exacerbated.
With a large number of banks shut down, and with those managing to survive facing an increasingly large number
of loans in distress, and unwilling to take on new customers, more and more businesses found themselves without
access to credit. Without credit, the one glimmer of hope for a recovery would be squashed. The depreciation of
the currency meant that exports should have boomed, as the goods from the region became cheaper, but to
expand exports, firms need to have working capital to produce more. As banks shut down and cut back on their
lending, firms could not even get the working capital required to maintain production, let alone to expand.
As the crisis progressed, unemployment soared, GDP plummeted, banks closed. The unemployment rate was up
fourfold in Korea, threefold in Thailand, tenfold in Indonesia. In Indonesia, almost 15 percent of males working in
1997 had lost their jobs by August 1998, and the economic devastation was even worse in the urban areas of the
main island, Java. In South Korea, urban poverty almost tripled, with almost a quarter of the population falling into
poverty; in Indonesia poverty doubled. In 1998, GDP in Indonesia fell by 13.1 percent, in Korea by 6.7 percent,
and in Thailand by 10.8 percent. Three years after the crisis, Indonesia’s GDP was still 7.5 percent below that
before the crisis, Thailand’s 2.3 percent lower. Communities in Thailand worked together to ensure that their
children’s education was not interrupted, with people voluntarily contributing to help keep their neighbors’ kids in
school. They also made sure that everyone had enough food, and because of this the incidence of malnutrition
did not increase. In Indonesia, it was poor urban workers- hardly well off by any standards- who were made most
destitute by the crisis. It is the erosion of the middle class, caused by usurious interest rates which threw small
businesses into bankruptcy, which will have the longest lasting effects on the social, political, and economic life of
the region. The IMF, in focusing on protecting investors, had forgotten about those in the countries it was
supposed to be helping; in focusing on financial variables, like exchange rates, it had forgotten the real side of
the economy. It had lost sight of its original mission.
In 1997, Japan offered $100 billion to help create the Asian Monetary Fund, in order to finance the required
stimulative actions. But the US Treasury did everything that it could to squelch the idea. The IMF joined in. The
reason for the IMF’s position was clear: While the IMF was a strong advocate of competition in markets, it didn’t
want competition in its own domain, and the AMF would provide that. The US Treasury, being the only
shareholder in the IMF with veto power, had similar motivations. The AMF would challenge US supremacy in
global economic control. It was widely known that Japan had considerable misgivings about the IMF policies. With
Japan, and possibly China, as the likely major contributors to the AMF, their voices would predominate, providing
a real challenge to American ‘leadership’. The squashing of the Asian Monetary Fund is still resented in Asia and
many officials have spoken out angrily about it. Three years after the crisis, the countries of East Asia finally got
together to begin, quietly, the creation of a more modest version of the AMF, under the innocuous name of the
Chang Mai Initiative, named after the city in northern Thailand where it was launched.
In retrospect, it is now clear that such economic fluctuations as in East Asia have always been part of market
economies. Almost every economic downturn comes to an end. But the Asian crisis was more severe than it
should have been, recovery took longer than it needed to, and the prospects for future growth are not what they
should be. To truly measure recovery, stabilization of exchange rates or interest rates is not enough. People do
not live off of exchange rates or interest rates. Workers care about jobs and wages. Although the unemployment
rate and real wages may have bottomed out, that is not enough for the worker who remains unemployed or who
has seen his income fall by a quarter. Today incomes in the countries of East Asia affected by the crisis are still
20 percent below what they would have been had their growth continued at the pace of the previous decade. The
effects of recession are long-lasting. There is an important implication to this: The deeper the recession today,
not only is output lower today, but the lower output is likely to be for years to come. In a way, this is good news,
since it means that the best medicine for today’s health of the economy and the best medicine for tomorrow’s
coincide. It implies that economic policy should be directed at minimizing the depth and duration of any economic
downturn. Unfortunately, this was neither the intention nor the impact of the IMF prescriptions.
By contrasting what happened in Malaysia and China, two nations that chose not to have IMF programs, with the
rest of East Asia, which did, the negative effects of the IMF policies can be seen clearly. While in Malaysia there
was a high level of nonperforming loans (15%), Malaysia’s Central Bank had imposed strong regulations which
had resulted in banks making adequate provisions for these losses. Moreover, Malaysia’s strong regulatory
stance had prevented banks from exposure to foreign exchange volatility (the danger of borrowing in dollars and
lending in ringgit), and had even limited the foreign indebtedness of the companies to which these banks lent. In
September 1998, Malaysia pegged the ringgit at 3.80 to the dollar, cut interest rates, and decreed that all
offshore ringgit be repatriated by the end of the month. The government also imposed tight limits on transfers of
capital abroad by residents in Malaysia and froze the repatriation of foreign portfolio capital for twelve months.
These measures were announced as short term, and were carefully designed to make it clear that the country
was not hostile to long-term foreign investment. Those who had invested money in Malaysia and had profits were
allowed to take them out. Some economists- those from Wall Street joined by the IMF- predicted disaster when
the controls were imposed, saying foreign investors would be scared off for years to come. They expected
foreign investment to plummet, the stock market to fall, and a black market in the ringgit, with its accompanying
distortions, to form. Pundits predicted that the economy would suffer, growth would be halted, the controls would
never be lifted, and that Malaysia was postponing addressing the underlying problems.
In fact, the outcome was far different. Malaysia converted the capital controls into an exit tax. Since rapid capital
flows into or out of a country cause large disturbances, they generate what economists call ‘large externalities’-
effects on other, ordinary people not involved in these capital flows. Such flows lead to massive disturbances of
the overall economy. Government has the right, even the obligation, to take measures to address such
disturbances. In general, economists believe that market-based interventions such as taxes are more effective
and have fewer adverse side effects than direct controls. Moreover, the tax could be gradually lowered, so that
there would be no large disturbance when interventions were finally removed. Things worked just as planned.
Malaysia removed the tax just as it had promised, one year after the imposition of the controls. In the one-year
interim, Malaysia had restructured its banks and corporations, proving the critics, who had said that it is only with
discipline that comes from free capital markets that governments ever do anything serious, wrong again. In
retrospect, it was clear that Malaysia’s capital controls allowed it to recover much more quickly, with a shallower
downturn, and with a far smaller legacy of national debt burdening future growth. The controls allowed it to have
lower interest rates than it could have otherwise had; the lower interest rates meant that fewer firms were put into
bankruptcy, and so the magnitude of publicly funded corporate bailout was smaller. The lower interest rates
meant too that recovery could occur with less reliance on fiscal policy, and consequently less government
borrowing. Today, Malaysia stands in a far better position than those countries that took IMF advice. Foreign
investment actually increased. Because investors are concerned about economic stability, and because Malaysia
had done a far better job in maintaining that stability than many of its neighbors, it was able to attract investment.
China was the other country that followed an independent course. It is no accident that the two large developing
countries spared the ravages of the global economic crisis- India and China- both had capital controls. While
developing world countries with liberalized capital markets actually saw their incomes decline, India grew at a rate
in excess of 5 percent and China at close to 8 percent. China achieved this by following the prescriptions of
economic orthodoxy. When faced with an economic downturn, respond with expansionary macroeconomic policy.
China seized the opportunity to combine its short-run needs with its long-run growth objectives. The rapid growth
over the preceding decade, anticipated to continue into the next century, created enormous demands on
infrastructure. There were large opportunities for public investments with high returns, including projects
underway that were sped up, and projects that were already designed but had been put on the shelf for lack of
funds. While making economic policy decisions, China was aware of the link between macrostability and
microeconomy. And China recognized the links between economics and political and social stability. In all
respects, China fully appreciated the systematic consequences of macroeconomic policies, consequences that
the IMF policies habitually overlooked. It is no accident that the only major East Asian country, China, to avert the
crisis took a course directly opposite that advocated by the IMF, and that the country with the shortest downturn,
Malaysia, also explicitly rejected an IMF strategy.
In Asia, many people believe in the conspiracy theory that IMF policies were either a deliberate attempt to weaken
East Asia- the region of the world that had shown the greatest growth over the previous forty years- or at least to
enhance the incomes of those on Wall Street and the other money centers. Though Stiglitz does not take this
stand, one can understand how this line of thinking developed: The IMF first told countries in East Asia to open up
their markets to hot short-term capital. The countries did it and money flooded in, but just as suddenly flowed
out. The IMF then said that interest rates should be raised and there should be fiscal contraction, and a deep
recession was induced. As asset prices plummeted, the IMF urged affected countries to sell their assets even at
bargain basement prices. It said the companies needed solid foreign management (conveniently ignoring that
these companies had a most enviable record of growth over the preceding decades, hard to reconcile with bad
management) and that this would only happen if the companies were sold to foreigners. The sales were handled
by the same foreign financial institutions that had pulled out their capital, precipitating the crisis. These banks
then got large commissions from their work selling the troubled companies or splitting them up, just as they had
got large commissions when they had originally guided the money into the countries in the first place. As the
events unfolded, cynicism grew even greater: some of these American and other financial companies didn’t do
much restructuring; they just held the assets until the economy recovered, making profits from buying at the fire
sale prices and selling at more normal prices.
Stiglitz believes that there is a simpler set of explanations- the IMF was not participating in a conspiracy theory,
but it was reflecting the interests and ideology of the Western financial community. Modes of operation which
were secretive insulated the institution and its policy from the kind of intensive scrutiny that might have forced it to
use models and adopt policies that were appropriate to the situation in East Asia.
The way the IMF approached the crisis has left in most of the countries a legacy of private and public debt. As a
result, firms will have to rely more on self-finance. In effect, capital markets will work less efficiently- a casualty of
the IMF’s ideological approach to improving market efficiency. And most importantly, growth of living standards
will be slowed. The IMF policies in East Asia had exactly the consequences that have brought globalization under
attack. The East Asia crisis made vivid to those in the more developed world some of the dissatisfaction that
those in the developing world have long felt. In the aftermath of this crisis, the IMF has not sought to explain why
its models failed to predict the course of events so miserably. Nor has it sought to develop an alternative
intellectual frame- implying that in the next crisis, it may well make the same mistakes.
Russia and Other Communist Transformations
Russia has fallen far short of what the advocates of the market economy had promised, or hoped for. For the
majority of those living in the former Soviet Union, economic life under capitalism has been even worse than the
old Communist leaders had said it would be. Prospects for the future are bleak. The middle class has been
devastated, a system of crony and mafia capitalism has been created, and the one achievement, the creation of a
democracy with meaningful freedoms, including free press, appears fragile at best, particularly as formerly
independent TV stations are shut down one by one.
The radical reformers in Russia were trying simultaneously for a revolution in the economic regime and in the
structure of society. The saddest commentary is that, in the end, they failed at both: a market economy in which
many old party apparatchiks had simply been vested with enhanced powers to run and profit from the enterprises
they formerly managed, in which former KGB officials still held the levers of power. There was one new
dimension: a few new oligarchs, able and willing to exert immense political and economic power.
Incomes today are markedly lower than they were a decade ago, and poverty is much higher. The pessimists see
the country as a nuclear power wavering with political and social instability. The optimists see a semi-
authoritarian leadership establishing stability, but at the price of the loss of some democratic freedoms. Today,
the economic prognosis is somewhat less bleak than it was at the time of the 1998 crisis, but it is no less
uncertain. The government barely made ends meet when oil prices- the country’s main exports- were high. It is
clear that something has gone wrong, not only in Russia but also in most of the more than twenty countries that
emerged from the Soviet empire.
The transition from communism to a market economy was more than just an economic experiment: it was a
transformation of societies and of social and political structures. Some of the Russian market reformers (as well
as their Western supporters and advisors) had very little faith or interest in democracy, fearing that if the Russian
people were allowed to choose, they would not choose the ‘correct’ (that is their) economic model. In Moscow,
early on, there was a healthy policy debate. Many were concerned, for instance, that the high exchange rate was
suppressing growth- and they were right. Others worried that devaluation would set off inflation- and they too
were right. These are complicated matters, and in democracies, they need to be debated and discussed. Russia
was trying to do just that, trying to open up the discussion to different voices. It was Washington- or more
accurately, the IMF and the US Treasury- that were afraid of democracy, that wanted to suppress debate. In
Eastern Europe and the former Soviet Union, when these ‘market reform’ benefits failed to materialize in country
after country, democratic elections rejected the extremes of market reform, and put social democratic parties or
even ‘reformed’ Communist parties, many with former Communists at the helm, into power. It is not surprising that
many of the market reformers showed a remarkable affinity to the old ways of doing business: in Russia,
President Yeltsin, with enormously greater powers than his counterparts in any Western democracy, was
encouraged to circumvent the democratically elected Duma (parliament) and to enact market reforms by decree.
The economic theory explaining the failure of communism was clear: Centralized planning was doomed to failure,
simply because no government agency could glean and process all the relevant information required to make an
economy function well. Without private property and the private motive, incentives- especially managerial and
entrepreneurial incentives- were lacking. The restricted trade regime, combined with huge subsidies and
arbitrarily set prices, meant the system was rife with distortions. It followed that replacing centralized planning with
a decentralized market system would cause a burst of economic output. The cutback in military expenditure
provided even more room for increases in the standard of living. Instead, however, the standard of living in
Russia, and many of the other East European transition countries, fell.
Seldom before had a country deliberately set out to go from a situation where government controlled virtually
every aspect of the economy to one where decisions occurred through markets. The People’s Republic of China
had begun its transition in the late 1970s, and was still far from a full-fledged market economy. In that time, it has
worked to establish institutions that underlay a market economy. It has had truly impressive success having close
to double-digit growth. The IMF studiously ignored China’s example, as well as the advice of Russian scholars,
whether they were experts in its history, economics, or society, for a simple reason: they believed that the market
revolution which was about to occur made all of the knowledge available from these other disciplines irrelevant.
What the market fundamentalists preached was textbook economics- an oversimplified version of market
economics which paid scant attention to the dynamics of change.
Textbook economics talk about market economies as if there are three essential ingredients: prices, private
property, and profits. Together with competition, these provide incentives, coordinate economic decision making,
ensuring that firms produce what individuals want at the lowest possible cost. But there has also long been
recognition of the importance of institutions. Most important are legal and regulatory frameworks, to ensure that
contracts are enforced, that there is an orderly way of resolving commercial disputes, that when borrowers cannot
repay what is owed, there are orderly bankruptcy procedure, that competition is maintained, and that banks that
take depositors are in a position to give the money back to depositors when they ask. This framework of laws and
agencies helps ensure that securities markets operate in a fair manner, that managers do not take advantage of
shareholders nor majority shareholders of minority shareholders. But, in Russia, while market reformers may
have mentioned this institutional infrastructure, they gave it short shrift. They tried to take a shortcut to
capitalism, creating a market economy without the underlying institutions, and institutions without the underlying
institutional infrastructure. Before you set up a stock market, you have to make sure there are real regulations in
place. A real and effective banking system requires strong banking regulations. New firms need to be able to
acquire land, and this requires a land market and land registration. In Soviet-era agriculture, farmers used to be
given the seeds and fertilizer they needed. They did not need to worry about getting these and other inputs
(such as tractors) or marketing their output. Under a market economy, markets for inputs and outputs had to be
created, and this required new firms or enterprises. Social institutions are also important. Under the old system
in the Soviet Union, there was no unemployment, and hence no need for unemployment insurance. Workers
typically worked for the same state enterprise for their entire lives, and the firm provided housing and retirement
benefits. There could not be much ‘restructuring’ without a social safety net. Unfortunately, neither a housing
market nor a real safety net existed in the new Russia of 1989.
As in a market economy, under the Soviet system there were prices, but the prices were set by government fiat,
not by the market. Some prices, such as those for basic necessities, were kept artificially low- enabling even
those at the bottom of the income distribution to avoid poverty. Prices for energy and natural resources also were
kept artificially low- which Russia could only afford because of its huge reservoirs of these resources. They had
to move from this distorted price system to a market price system. They had to create markets and the
institutional infrastructure that underlies it; and they had to privatize all the property which previously had
belonged to the state. If the challenges posed by transition were great, so were the opportunities. Russia was a
rich country. While three quarters of a century of communism may have left its populace devoid of an
understanding of market economics, it had left them with a high level of education, especially in technical areas so
important for the New Economy. After all, Russia was the first country to send a man into space.
In the enthusiasm to get on with a market economy, most prices were freed overnight in 1992, setting in motion an
inflation that wiped out savings, and moved the problem of macrostability to the top of the agenda. Everybody
recognized that with hyperinflation (inflation in double-digit rates per month), it would be difficult to have a
successful transition. This high inflation entailed tightening monetary policy, which meant raising interest rates.
There is little evidence that lowering inflation below a moderate level (so dealing with the hyperinflation, but not
taking it too far) increases growth. The most successful countries, like Poland, ignored the IMF’s pressure and
maintained inflation at around 20 percent through the critical years of adjustment. The IMF’s star pupils, like the
Czech Republic, which pushed inflation down to 2 percent, saw their economy stagnate. The high interest rate
clearly stifled new investment. Throughout the 1990s, the IMF focused on making countries work on getting
budgets in order and controlling the growth of money supplies. Although when conducted in moderation, this
stabilization may be a prerequisite to growth, it is hardly a growth strategy. In fact, the stabilization strategy has
contracted aggregate demand. This decrease in aggregate demand has interacted with misguided restructuring
strategies, to contract aggregate supply. In six years, Russia's productive capacity was cut by more than 40
percent- far deeper than the reduction in defense, a far greater loss in capacity than occurs in any but the worst
wars. Many of the new privatized firms, even those who began without an eye on looting them, saw that they
could not expand and switched to asset stripping. The tight monetary policies also contributed to the use of
barter. With a shortage of money, workers were paid in kind- with whatever it was that the factory produced or
had available. While high rates of inflation are costly to an economy because they interfere with the workings of
the price system, barter is every bit as destructive to that system, and the excesses of monetary stringency simply
substituted one set of inefficiencies for a possibly even worse set.
While most of the prices were completely freed, some of the most important prices were kept low- those for natural
resources. With a newly declared ‘market economy’, this created an open invitation: If you can buy oil and resell it
in the West, you could make millions or even billions of dollars. So people did. Instead of making money by
creating new enterprises, they got rich from exploiting the mistaken government policies.
Liberalization and stabilization were two of the pillars of the radical reform strategy. Rapid privatization was a
third. But the first two pillars put obstacles in the way of the third. The initial high inflation had wiped out the
savings of most Russians so there were not enough people in the country who had the money to buy the
enterprises to be privatized. Even if they could afford to buy the enterprises, it would be difficult to revitalize them,
given the high interest rates and lack of financial institutions to provide capital. The radical reform strategy did
not work: GDP in post-1989 Russia fell, year after year. What had been envisioned as a short transition
recession turned into one of a decade or more. In the period of 1940-46 the Soviet Union industrial production
fell 24 percent. In the period 1990-99, Russian industrial production fell by almost 60 percent- even greater than
the fall in GDP (54%). Farm livestock decreased by half, investment in manufacturing came almost to a stop.
Russia was able to attract some foreign investment in natural resources; Africa had shown long ago that if you
price natural resources low enough, it is easy to attract foreign investment in them.
Part of the problem with Russia’s transition was the people the US and IMF decided to ally themselves with. The
‘good guys’ were the apparatchiks who had run businesses. These were practical men with whom we could deal.
While some of these ‘practical men’ were ready to steal as much of the state’s wealth for themselves and their
friends as they could get away with, they were clearly no left-wing ideologues. Many of those with whom we allied
ourselves were less interested in creating the kind of market economy that has worked so well in the West than
enriching themselves. Within Russia, the United States was justly perceived as having allied itself with corruption.
As time went on, and the problems with the reform strategy and the Yeltsin government became clearer, the
reactions of people in the IMF and at the US Treasury was typical: to ignore the facts, to deny the reality, to
suppress the discussion, to throw more good money at the bad, and keep talking about how Russia was just
about to ‘turn a corner’. By siding so firmly for so long with those at the helm when the huge inequality was
created through a corrupt privatization process, the US, the IMF, and the international community have indelibly
associated themselves with policies that, at best, promoted the interests of the wealthy at the expense of the
average Russian. In retrospect, the West’s long-term interests would have been far better served had we stayed
out of close involvement with particular leaders and simply provided broad-based support to democratic
processes, because there were a great many people in Russia that truly wanted to build a well-functioning
democracy.
The IMF told Russia to privatize as fast as possible; how privatization was done was viewed as secondary. But
without the institutional infrastructure (like corporate governance), the privatization had no positive effect on
growth. With rapid privatization, firms sought to establish monopolies and cartels, to enhance their profits,
undisciplined by effective antitrust policies. And as so often happens, the profits of monopoly prove especially
alluring to those who are willing to resort to mafia-like techniques either to obtain market dominance or to enforce
collusion. Privatization, accompanied by the opening of the capital markets, led not to wealth but to asset
stripping, which could be done easily due to the lack of governance. It was perfectly logical. Privatization in
Russia turned over large national enterprises, typically to their old managers. Those insiders knew how uncertain
and difficult the road ahead was. They dared not wait for the creation of capital markets and the hosts of other
changes that would be required for them to reap the full value of any investments and restructuring. They
focused on what they could get out of the firm in the next few years, and all too often, this was maximized by
stripping assets. Also, an oligarch, who has just been able to use political influence to garner assets worth
billions, after only paying a pittance, would naturally want to get his money out of the country. Keeping money in
Russia meant investing in a country in deep depression, and risking not only low returns but having the assets
seized by the next government, which would inevitably complain, quite rightly, about the ‘illegitimacy’ of the
privatization process. Anyone smart enough to be a winner in the privatization sweepstakes would be smart
enough to put their money in the booming US stock market, or into the safe haven of secretive offshore bank
accounts. Not surprisingly, billions poured out of the country.
Privatization was supposed to eliminate the role of the state in the economy. Privatization did reduce the role of
the central government, but that devolution left the local and regional governments with far wider discretion. A
city could use a whole host of regulatory and tax measures to extort ‘rents’ from firms that operated in their
jurisdiction. In advanced industrial countries there is a rule of law which keeps local and state governments from
abusing their potential powers; not so in Russia. In advance industrial countries, competition among communities
makes each try to make itself more attractive to investors. But in a world in which high interest rates and an
overall depression make such investments unlikely in any case, local governments spent little time creating
attractive ‘environments for investment’ and focused instead on seeing how much they could extract from existing
enterprises- just as the owners and managers of newly privatized firms themselves did. There existed an
environment where people reasoned that they had better take what they could grab before somebody else did. It
was a race to the bottom and there were incentives for stripping assets at every level.
Privatization, as it was imposed in Russia (as well as far too many of its former Soviet bloc dependencies),
undermined confidence in government, in democracy, and in reform. It even involved giving away Russia’s rich
natural resources before it had in place a system to collect natural resource taxes and a few friends and
associates of Yeltsin became billionaires. At the same time, the country was unable to pay pensioners their $15 a
month pension. The most egregious example of bad privatization was the loans-for-share program. In 1995, the
government, instead of turning to the Central Bank for needed funds, turned to private banks. Many of these
private banks belonged to friends of the government who had been given bank charters. In an environment with
underregulated banks, the charters were effectively a license to print money, to make loans either to themselves
or their friends or to the government. As a condition of the loan, the government put up shares of its own
enterprises as collateral. Then- surprise!- the government defaulted on its loans; the private banks took over the
companies in what might be viewed as a sham sale (though the government did go through the charade of having
‘auctions’); and a few oligarchs became instant billionaires. These privatizations had no political legitimacy. And
the fact that they had no legitimacy made it even more imperative that the oligarchs take their funds quickly out of
the country- before a new government that might try to reverse the privatizations or undermine their position came
into power. The loans-for-share scheme constituted the final stage of the enrichment of the oligarchs, the small
band of people (some of whom owed their origins partly to mafia-like connections) who came to dominate not just
the economic but the political life of the country. At one point, they claimed to control 50 percent of the country’s
wealth. Russia’s oligarchs stole assets, stripped them, leaving their country much poorer. The enterprises were
left on the verge of bankruptcy, while the oligarch’s bank accounts were enriched.
Market economies entail a host of economic relationships- exchanges. Many of these exchanges involve matters
of trust. An individual lends money, trusting that he will be repaid. Backing up this trust is a legal system. If
individuals do not live up to their contractual obligations, they can be forced to do so. If an individual steals
property from another, he can be brought to court. But in countries with mature market economies and adequate
institutional infrastructures, individuals and corporations resort only occasionally to litigation. Economists often
refer to the glue that holds society together as ‘social capital’. Random violence and Mafia capitalism are often
cited as reflections of the erosion of social capital, but in some of the countries of the former Soviet Union one
could see everywhere, in more subtle ways, direct manifestation of the erosion of social capital. It is not just a
question of the misbehavior of a few managers; it is an almost anarchic theft by all from all. In the early days of
the transition, there was so little confidence in the future that each individual took what he could. The way in
which transition proceeded in Russia served to erode the social capital. One got wealthy not by working hard or
by investing, but by using political connections to get state property cheaply in privatizations. The social contract,
which bound citizens together with their government, was broken, as pensioners saw the government giving away
valuable state assets, but claiming that it had no money to pay their pensions. And the erosion of social capital
created an environment that was not conducive to investment.
There were glimpses of recovery seen in 1997, but they were not to last long. In 1998, the fallout from the East
Asian crisis hit. The crisis had led to a general skittishness about investing in emerging markets, and investors
demanded higher returns to compensate them for lending capital to these countries. Mirroring the weaknesses in
the GDP and investment were weaknesses in public finance: the Russian government had been borrowing
heavily. The government, pressured by the US, the World Bank, and the IMF to privatize rapidly, had turned over
its states assets for a pittance, and done so before it had put into place an effective tax system. The government
created a powerful class of oligarchs and businessmen who paid but a fraction of what they owed in taxes, much
less what they would have paid in virtually every other country.
Thus, at the time of the East Asia crisis, Russia was in a peculiar position. It had an abundance of natural
resources, but its government was poor. The government was virtually giving away its valuable state assets, yet it
was unable to provide pensions for the elderly or welfare payments for the poor. The government was borrowing
billions from the IMF, becoming increasingly indebted, while the oligarchs, who had received such largesse from
the government, were taking billions out of the country. This rickety tower collapsed when oil prices fell. Due to
recessions and depressions in Southeast Asia, oil demand not only failed to expand as expected but actually
contracted. The resulting imbalance between demand and supply of oil turned into a dramatic fall in crude oil
prices (down over 40% in the first six months of 1998 compared to the average prices in 1997). Oil is both a
major export commodity and a source of government tax revenue for Russia, and the drop in prices had a
predictably devastating effect.
It was clear that the ruble was overvalued. Russia was flooded with imports, and domestic producers were having
a hard time competing. Investment had halted, and the country was not producing consumer goods. The
overvalued exchange rate- combined with the other macroeconomic policies foisted on the country by the IMF-
had crushed the economy, and while the official unemployment rate remained subdued, there was massive
disguised unemployment. The managers of many firms were reluctant to fire workers, given the absence of an
adequate safety net. While the workers only pretended to work, the firms only pretended to pay. Wage payments
fell into massive arrears, and when workers were paid, it was often with bartered goods rather than rubles. For
the new class of businessmen the overvalued exchange rate was a boon. They needed fewer rubles to buy their
Mercedes, their Chanel handbags, and imported Italian gourmet foods. For the oligarchs trying to get their
money out of the country, too, the overvalued exchange rate was a boon- it meant that they could get more
dollars for their rubles, as they squirreled away their profits in foreign bank accounts. Speculators could also see
how much in the way of reserves were left, and as reserves dwindled, betting on devaluation became increasingly
a one-way bet. They risked almost nothing betting on the ruble’s crash. As expected, the IMF came to the rescue
with $4.8 billion in July 1998. By inducing greater foreign borrowing, by making Russia’s position once it devalued
so much less tenable, the IMF was partly culpable for the eventual suspension of payments by Russia on its
debts.
When the crisis hit, the IMF led the charge pushing for a rescue package of $22.6 billion. This was a hotly
debated topic, as it made it easier for the Russian government to put off meaningful reforms, such as collecting
taxes from the oil companies. The evidence of corruption in Russia was clear. The World Bank’s own study of
corruption had identified that region as among the most corrupt in the world. The West knew that much of those
billions would be diverted from their intended purposes to the families and associates of corrupt officials and their
oligarch friends. The IMF’s bailout money was supposed to be used to support the exchange rate. However, if a
country’s currency is overvalued and this causes the country’s economy to suffer, maintaining the exchange rate
makes little sense. If the exchange rate support works, the country suffers. But in the more likely case that the
support does not work, the money is wasted, and the country is deeper in debt.
Russia was a naturally resource-rich country. If it got its act together, it didn’t need money from the outside; and if
it didn’t get its act together, it wasn’t clear that any money from the outside would make much of a difference.
Under either scenario, the case against giving money seemed compelling. Three weeks after the loan was made,
Russia announced a unilateral suspension of payments and a devaluation of the ruble. The ruble crashed. The
August 17, 1998 announcement precipitated a global financial crisis. Interest rates soared higher than they had
been at the peak of the East Asian crisis. Even developing countries who had been pursuing sound economic
policies found it impossible to raise funds. Brazil’s recession deepened, and eventually it too faced a currency
crisis. Argentina and other Latin American countries only gradually recovering from previous crises were again
pushed to the brink and into crisis. Even the United States did not remain untouched. The New York Federal
Reserve Bank engineered a private bailout of one of the nation’s largest hedge funds, Long Term Capital
Management, since the Fed feared its failure could precipitate a global financial crisis.
Those who had argued against providing Russia the loan had predicted the money might sustain the exchange
rate for three months; it lasted three weeks. They felt it would take days or even weeks for the oligarchs to bleed
the money out of the country; it took merely hours and days. The Russian government even ‘allowed’ the
exchange rate to appreciate. This meant the oligarchs would need to spend fewer rubles to purchase their
dollars. Just days after the loan was made, the billions of dollars that the IMF had given (loaned) Russia was
showing up in Cypriot and Swiss bank accounts. It was of course, not just the oligarchs who benefited from the
rescue. The Wall Street and other Western investment bankers, who had been among those pressing the
hardest for a rescue package, knew it would not last. They too took the short respite provided by the loan to
rescue as much as they could, to flee the country with as much as they could salvage. By lending money to
Russia for a doomed cause, IMF policies led Russia into deeper debt, with nothing to show for it. The cost of the
mistake was not borne by the IMF officials who gave the loan, or America who had pushed for it, or the Western
bankers and the oligarchs who benefited from the loan, but by the Russian taxpayer.
The expectations for economic growth were not realized in most of the economies in transition from Communism
to the market. Only a few of the former Communist countries- such as Poland, Hungary, Slovenia, and Slovakia-
have a GDP equal to that of a decade ago. For the rest, the magnitudes of the declines in incomes are so large
that they are hard to fathom. According to World Bank data, in 2000, Russia had a GDP of less than two-thirds of
what it was in 1989. Moldova’s decline is the most dramatic, with output in 2000 of less than a third of what it was
a decade ago. Ukraine’s 2000 GDP was just a third of what it was a decade prior as well. Most individuals have
experienced a marked deterioration in their basic standard of living, reflected in a host of social indicators. The
average life expectancy is about three years shorter than it was in 1989. Survey data of household consumption
also corroborates a marked decline in standards of living, on par with those suggested by the fall in GDP
statistics. Given that the government was spending less of defense, there should have been more money to
improve standards of living, not less.
While the size of the economic pie was shrinking, it was being divided up more and more inequitably so the
average Russian was getting a smaller and smaller slice. In 1989, only 2 percent of those living in Russia were in
poverty. By late 1998, that number had soared to 23.8 percent, and more than 40 percent of the population was
living on less than $4 a day. The statistics for children revealed an even deeper problem, with more than 50
percent living in families in poverty. Other post-Communist countries have seen comparable, if not worse,
increases in poverty. While the transition has greatly increased the number of those in poverty, and led a few at
the top to prosper, the middle class in Russia has been perhaps the hardest hit. The inflation first wiped out their
savings. With wages not keeping up with inflation, their real incomes fell. Cutbacks in expenditure on education
and health further eroded their standards of living. Those who could emigrated. (Some countries, like Bulgaria,
lost 10% or more of their population and an even larger fraction of their educated workforce). These losses are
important not just for what they imply today for those living in Russia, but for what they portend for the future:
historically, the middle class has been central to creating a society based on the rule of law and democratic
values.
Under the old regime, incomes were kept similar by suppressing wage differences. The Communist system, while
it did not make for an easy life, avoided the extremes of poverty, and kept living standards relatively equal, by
providing a high common denominator of quality for education, housing, health care and child care services.
Russia today has a level of inequality comparable with the worst in the world, those Latin American societies which
were based on a semi-feudal heritage. Russia has gotten the worst of all possible worlds- an enormous decline in
output and an enormous increase in inequality. And the prognosis for the future is bleak: extremes of inequality
impede growth, particularly when they lead to social and political instability. A long history of political reforms
suggests that the distribution of income does matter. It has been the middle class that has demanded reforms
that are often referred to as ‘the rule of law’. The very wealthy usually do far better for themselves behind closed
doors, bargaining special favors and privileges. Today, in Russia, we do not see demands for strong competition
policy forthcoming from the oligarchs, the new monopolists. The oligarchs do have some incentive for a legal
structure now though and have been pushing for change in some areas. They have made these demands to
help create stability and protect their money, now that they have sprinted way out in front of the pack.
The control of the media was a big source of power for the oligarchs. The US and IMF officials paid little attention
to the dangers posed by the concentration of media power; rather, they focused on the rapidity of privatization, a
sign that the privatization process was proceeding apace. And they took comfort, indeed even pride, in the fact
that the concentrated private media was being used, and used effectively, to keep their friends Boris Yeltsin and
the so-called reformers in power. One of the reasons that it is important to have an active and critical media is to
ensure that the decisions that get made reflect not just the interests of a few but the general interests of society.
One of the consequences with the failure to create an effective, independent, and competitive media in Russia
was that the policies- such as the loans-for-share scheme- were not subjected to the public critique they
deserved. Even in the West, however, the critical decisions about Russian policy, both at the international
economic institutions and in the US Treasury, went on largely behind closed doors. Neither the taxpayers in the
West, to whom these institutions were supposed to be accountable, nor the Russian people, who paid the ultimate
price, knew much about what was going on at the time.
There are many in Russia (and elsewhere) who believe the failed policies were not just accidental: the failures
were deliberate, intended to eviscerate Russia, to remove it as a threat for the indefinite future. Stiglitz believes
that the IMF actually though the policies they were advocating would succeed. They believed that a strong
Russian economy and a stable Russian reform-oriented government were in the interests of both the US and
global peace. But the policies were not entirely altruistic. US economic interests- or more accurately, US financial
and commercial market interests- were reflected in the policies. But it was not just Wall Street's direct interests
that influenced policy; it was the ideology that prevailed in the financial community. For instance, Wall Street
regards inflation as the worst thing in the world: it erodes the real value of what is owed to creditors, which leads
to increases in interest rates, which in turn lead to declines in bond prices. To financers, unemployment is far
less of a concern. For Wall Street, nothing could be more sacrosanct than private property; no wonder the
emphasis on privatization. Their commitment to competition is far less passionate. And notions of social capital
and political participation may not even appear on their radar screen; they feel far more comfortable with an
independent central bank than one whose actions are more directly under the control of the political processes.
Broader special economic interests in the United States affected policies in ways that conflicted with broader
national interests and made the country look more than a little hypocritical. The United States supports free
trade, but all too often, when a poor country does find a commodity it can export to the United States; domestic
American protectionist interests are galvanized. This mix of labor and business interests uses the many trade
laws- officially referred to as 'fair trade laws', but known outside the US as 'unfair fair trade laws'- to construct
barbed-wire barriers to imports These laws allow a company that believes a foreign rival is selling a product below
cost to request that the government impose special tariffs to protect it. Selling products below cost is called
'dumping', and the duties are called dumping duties. Often, however, the US government determines costs on the
basis of little evidence and in ways which make little sense. To most economists, the dumping duties are simply
naked protectionism. The way that dumping laws are typically implemented, countries can be charged with
dumping even when they were- from an economic point of view- not dumping. The US estimates cost of
production using a peculiar methodology, which, if applied to American firms, would conclude that most American
firms were dumping as well; but worse, the Department of Commerce, which acts simultaneously as prosecutor,
judge and jury, estimates costs based on what it call BIA, best information available, which is typically provided by
the American firms trying to keep out foreign competition. A most egregious example occurred in the early
nineties concerning Russian aluminum exports. Russia was selling its aluminum at international prices. Given the
excess capacity in its industry and the low price of Russian electricity, much if not all of what it was selling on the
international markets was being sold above its cost of production.
In early 1994, a shocking proposal was made by Paul O'Neill, head of Alcoa: a global economic cartel. Cartels
work by restricting output, thereby raising prices. O'Neill's interest was of no surprise, but what was surprising
was the idea that the US government would not only condone a cartel but actually play a pivotal role in setting one
up. In a heated subcabinet meeting, a decision was made to support the creation of an international cartel.
People in the Council of Economic Advisors and the Department of Justice were livid. What makes market
economics work is competition. Cartels are illegal inside the United States, and they should be illegal globally.
For the United States now to help create a global cartel was a violation of every principle. Here, however, more
was at stake. Russia was struggling to create a market economy. The cartel would hurt Russia, by restricting its
sales of one of the few goods that it could market internationally. Not to mention that creating the cartel would be
teaching Russia the wrong lesson about how market economics work in practice. Reformers within the Russian
government were adamantly opposed to the establishment of the cartel, for obvious reasons. They knew the
quantitative restrictions that the cartel would impose would give more power back to the old-line ministries. With a
cartel, each country would be given certain quotas, amounts of aluminum they could produce or export. The
ministries would control who got the quotas. This was the kind of system with which they were familiar, and in the
new Mafiaized Russia, it would also give rise to a bloodbath in the struggle over who got the quotas. The State
Department, with its close connections to the old-line state ministries, supported the establishment of a cartel.
The State Department prized order over all else, and cartels do provide order. At least for a while, the cartel did
work. Prices were raised. The profits of Alcoa and other producers were enhanced. The American consumers-
and consumers throughout the world- lost, and indeed, the basic principles of economics, which teach the value
of competitive markets, show that the losses to consumers outweigh the gains to producer.
The aluminum case was not the first, nor would it be the last instance, where special interests dominated over the
national and global goal of a successful transition. At the end of the Bush administration and the beginning of the
Clinton administration, a historical 'swords to plowshares' agreement was made between Russia and the United
States. A US government enterprise called the United States Enrichment Corporation (USEC) would buy Russian
uranium from deactivated nuclear warheads and bring it to the United States. The uranium would be de-enriched
so that it could no longer be used for nuclear weapons, and would then be used in nuclear power plants. The
sale would provide Russia with needed cash, which it could use to better keep its nuclear material under control.
Unbelievable as it may seem, the fair trade laws were again invoked, to impede the transfer. The American
uranium producers argued that Russia was dumping uranium on US markets. Just as in the case of aluminum,
there was no economic validity to this charge. However, the fair trade laws are not written on the basis of
economic principles. They exist solely to protect American industries adversely affected by imports. The
Department of Commerce and the US Trade Representative were- with high-level coaxing- finally persuaded to
propose changes in the laws to Congress. Congress turned the proposals down.
Equally striking is what happened next, in the mid-1990s. Privatization advocates in the United States thought of
something that few others would, or could, privatize: USEC, which not only enriches uranium for nuclear reactors
but also for atomic bombs. The privatization was beset by problems. USEC had been entrusted with bringing the
enriched uranium from Russia; as a private firm, this was a kind of monopoly power that would not have passed
scrutiny of the antitrust authorities. Worse still, it had every incentive to keep the Russian uranium out of the
United States. This was a real concern: there were major worries about nuclear proliferation- about nuclear
material getting into the hands of a rogue state or terrorist organization- and having a weakened Russia with
enriched uranium to sell to anyone willing to pay was hardly a pretty picture. USEC adamantly denied that it would
ever act counter to broader US interests, and affirmed that it would always bring in Russian uranium as fast as the
Russians were willing to sell; but the very week that it made these protestations, a secret agreement between
USEC and the Russian agency came to light. The Russians had offered to triple their deliveries, and the USEC
no only turned them down but paid a handsome amount in what could only be termed 'hush money' to keep the
offer (and USEC's refusal) secret.
Interestingly, this, America's only major privatization of the decade, was beset with problems arguably as bad as
those that have befallen privatization elsewhere. Indeed, at one point, it looked as if all imports to the US might be
held up. In the end, USEC asked for huge subsidies to continue with the importation. The rosy economic picture
painted by USEC (and the US Treasury) proved false, and investors became angry as they saw share prices
plummet. There was also nervousness about a firm with bare financial viability in charge of our nation's
production of enriched uranium.
Russia had a crash course in modern economics, and we were the teachers. They were told that trade
liberalization was necessary for a successful market economy, yet when they tried to export aluminum and
uranium (and other commodities as well) to the United States, they found the door shut. They were told that
competition was vital (though not much emphasis was put on this), yet the US government was at the center of
creating a global cartel in aluminum, and gave monopoly rights to import enriched uranium to the US monopoly
producer. They were told to privatize rapidly and honestly, yet the one attempt at privatization by the US took
years and years, and in the end its integrity was questioned. The United States lectured everyone, especially in
the aftermath of the East Asia crisis, about crony capitalism and its dangers. Yet issues of the use of influence
appeared front and center. If the West's preaching is not taken seriously everywhere, we should understand
why. It is not just past injuries, such as unfair trade treaties. It is what we are doing today. Others look not only
at what we say, but also at what we do. It is not always a pretty picture.
Sadly, for the most part, Russia must treat what has happened as what it really was: pillage of national assets, a
theft for which the nation can never be recompensated. Russia's objective in the future must be to try to stop
further pillage, to attract legitimate investors by creating a rule of law and, more broadly, an attractive business
climate. The devaluation of the ruble after the 1998 crisis has benefited Russia, showing that IMF policies had
indeed been stifling the economy all along. The devaluation was combined with a stroke of luck- the enormous
increase in oil prices in the late 1990s- fueled a recovery, from an admittedly low starting point. There have been
lasting benefits from this growth spurt; some of the enterprises that took advantage of the favorable
circumstances seem to be on the road to new opportunities and continued growth. There are other positive
signs: some of those who took advantage of the system of ersatz capitalism to become very wealthy are working
for a change in the rules, to make sure that what they did to others cannot be done to them. There are moves in
some quarters for better corporate governance- some of the oligarchs, while they are not willing to risk all of their
money in Russia, would like to entice others to risk more of theirs, and know that to do so they have to behave
better than they have in the past. But there are other, less positive signs. Even in the heyday of very high oil
prices, Russia was barely able to make its budget balanced; it should have been putting money aside for the
likelihood of a 'rainy day' when oil prices come down. The impacts of devaluation are mostly felt in the first two
years. But at the lower growth rates that are now emerging, Russia will need another decade or two, or more, just
to catch up to where it was in 1990- unless there are some marked changes.
Growth will only succeed if Russia creates an investment-friendly environment. This entails actions at all levels of
government. Good policies at the national level can be undone by bad policies at the local and regional level.
Regulations at all levels can make it difficult to establish new businesses. Unavailability of land can be an
impediment just as lack of availability of capital can be. Privatization does little good if local governments squeeze
local firms so hard that they have no incentive to invest. This implies that issues of federalism have to be
attacked head-on. A federalist structure that provides compatible incentives at all levels has to be put into place.
This will be difficult. Policies aimed at curtailing abuses at lower levels of government can themselves be abused,
to give excessive power to the center, and deprive local and regional authorities of the capacity to devise creative
and entrepreneurial growth strategies. But there is one factor essential to establishing a good business climate,
something which will prove particularly difficult to achieve given what has happened over the past decade: political
and social stability. The huge inequality, the enormous poverty, which has been created over the past decade,
provides fertile ground for a variety of movements, from nationalism to populism, some of which might not only be
a threat to Russia's economic future but to global peace. It will be difficult- and likely take considerable time- to
reverse the inequality that was created so quickly.
Russia must also do a better job collecting taxes. Collections should be least difficult in Russia’s dominant natural
resource businesses, since revenues and output in the natural resources sector are in principle easily monitored,
so taxes should be easy to collect. Russia must put firms on notice that if taxes are not paid in , say, sixty days,
their property will be seized. If taxes are not paid and the government does seize the property, it can reprivatize it
in a way that has more legitimacy than the discredited loans-for-share privatization under Yeltsin. On the other
hand, if the businesses do pay their taxes, Russia, the Russian government, will have the resources to attack
some of the important outstanding problems. And just as those who owe taxes must pay what they owe, those
who owe money to banks- especially the banks that are now in the hands of the government as a result of
defaults- must be made to pay those debts. Again, this may entail an effective renationalization to be followed by
a more legitimate privatization than had occurred previously.
The success of this agenda is predicated on there being a relatively honest government interested in improving
the common wealth. We in the West should realize this: there is relatively little that we can do to bring that about.
We can help support the kinds of institutions that are the underpinnings of democracies- building up think tanks,
creating space for public dialogue, supporting independent media, helping to educate a new generation that
understands how democracies work. At the national, regional, and provincial level there are many young officials
who would like to see their country take a different course, and broad-based support- intellectual as much as
financial- could make a difference.
As we forge broader democratic interactions, we should distance ourselves from those that are allied to the power
structures of the past as well as the newly emerging power structures of the oligarchs- at least as far as realpolitik
will allow. This above all else: We should do no harm. IMF loans to Russia were harmful. It is not only that these
loans and the policy decision behind them have left the country more indebted and impoverished, and maintained
exchange rates at high levels that squelched the economy; they were also intended to maintain the existing
groups in power, as corrupt as it was clear they were, so to the extent that they succeeded in this deliberate
intervention in the political life of the country, they arguably set back a deeper reform agenda that went beyond
creating a particular, narrow vision of a market economy to the creation of a vibrant democracy. Russia now has
a fragile democracy, far better than the totalitarian regime of the past. It suffers from a largely captive media-
formerly, too much under the control of a few oligarchs, now too much under the control of the state- but a media
that still presents a diversity of viewpoints far wider than under the state control system of the past. Young, well-
educated, dynamic entrepreneurs, while they too often seek to migrate to the West rather than face the difficulties
of doing business in Russia or the other former Soviet republics, represents the promise of a more vibrant private
sector in the future.
In the end, Russia and its leaders must be held accountable for Russia’s recent history and its fate. To a large
extent, Russians, at least a small elite, created their country’s predicament. Russians made the key decisions-
like the loans-for-share privatization. Arguably, the Russians were far better at manipulating Western economic
institutions than the Westerners were at understanding Russia. Senior government officials, like Anatoly Chubais,
have openly admitted how they misled (or worse, lied to) the IMF. When Chubais was asked if the Russian
government has the right to lie to the IMF about the true fiscal situation, he literally said: “In such situations, the
authorities have to do it. We ought to. The financial institutions understand, despite the fact that we conned
them out of $20 billion, that we had no other way out.” But we in the West, and our leaders, have played a far
from neutral and not insignificant role. The IMF let itself be misled, because it wanted to believe that its programs
were working, because it wanted to continue lending, because it wanted to believe that it was reshaping Russia.
The support, the policies- and the billions of dollars of IMF money- may not just have enabled the corrupt
government with its corrupt policies to remain in power; they may even have reduced pressure for meaningful
reforms. Today, just as Russia begins to hold its leaders accountable for the consequences of their decisions, we
too should hold our leaders accountable.
Conclusion
Countries that have grown faster have done a better job of reducing poverty, as China and East Asia amply
demonstrate. It is also true that poverty eradication requires resources, resources that can only be obtained with
growth. But this correlation does not prove that trickle-down strategies constitute the best way to attack poverty.
On the contrary, the statistics show that some countries have grown without reducing poverty at all, while some
countries have been much more successful in reducing poverty than others, regardless of their growth rate.
The issue is not whether one is in favor of or against growth. Some policies promote growth but have little effect
on poverty; some promote growth but actually increase poverty; and some promote growth and reduce poverty at
the same time. The last are called pro-poor growth strategies. Policies like land reform or better access to
education for the poor which hold out the promise of enhanced growth and greater equality. And sometimes,
unfortunately seen all too often, there are lose-lose policies where there is little if any gain in growth but a
significant increase in inequality.
Understanding the choices requires understanding the causes and nature of poverty. It is not that the poor are
lazy; they often work harder, longer hours, than those who are far better off. Many are caught in a series of
vicious spirals: lack of food leads to ill health, which limits their earning ability, leading to still poorer health. Barely
surviving, they cannot send their children to school, and without an education, their children are condemned to a
life of poverty. Poverty is passed on from one generation to another. Poor farmers cannot afford to pay the
money for the fertilizers and the high-yielding seeds that would increase their productivity. This is but one of
many vicious cycles facing the poor. In poor countries, such as Nepal, the impoverished have no source of
energy other than the neighboring forests; but as they strip the forests for the bare necessities of heating and
cooking, the soil erodes, and as the environment degrades, they are condemned to a life of ever-increasing
poverty.
Along with poverty come feelings of powerlessness. The poor feel that they are voiceless, and that they do not
have control over their own destiny. They are buffeted by forces beyond their control. And the poor feel
insecure. Not only is their income uncertain- changes in economic circumstances beyond their control can lead to
lower wages and a loss of jobs. They face health risks and continual threats of violence, sometimes from other
poor people trying against all odds to meet the needs of their families, sometimes from police and others in
positions of authority. While those in developed countries fret about the inadequacies of health insurance, those
in developing countries must get by without any form of insurance- no unemployment insurance, no health
insurance, and no retirement insurance. The only safety net is provided by family and community, which is why it
is so important, in the process of development, to preserve these bonds.
The IMF seems to ignore these deeper issues, though it’s often difficult to ascertain what they do consider.
Today, in spite of the repeated discussions of openness and transparency, the IMF still does not formally
recognize the citizen’s basic ‘right to know’: there is no Freedom of Information Act to which an American, or a
citizen of any other country, can appeal to find out what this international public institution is doing. The
international institutions have thus escaped the kind of direct accountability that we expect of public institutions in
modern democracies. This is something that absolutely must change if we are to see improvements in how things
are done. The time has come to ‘grade’ the international economic institutions’ performances and to look at some
of those programs they prescribed- and how well, or poorly, they did in promoting growth and reducing poverty.
Even if there remains a gap between rhetoric and reality, the recognition that those in the developing country
ought to have a major voice in their programs is important. But if the gap persists for too long or remains too
great, there will be an increased sense of disillusionment with the globalization process. Already, in some
quarters, doubts are being raised, and increasingly loudly.
There are alternatives to strategies to the IMF approach- strategies that differ not only in emphases but even in
policies; strategies, for instance, which include land reform but do not include capital market liberalization, which
provide for competition policies before privatization, which ensure that job creation accompanies trade
liberalization. These alternatives make use of markets, but recognize that there is an important role for
government as well. They recognize the importance of reform, but that reforms need to be paced and
sequenced. They see change not just as a matter of economics, but as a broader evolution of society. There
have been successes in the developing world which demonstrate that development and transition are possible;
the successes in development are well beyond that which almost anyone imagined a half century ago. The fact
that so many of the successes followed strategies that were markedly different from those of the Washington
Consensus is telling.
There clearly have been problems with how the IMF and other international financial institutions have proceeded
with development. The IMF should consult widely within a country as it makes its assessments and designs its
programs. Those within the country are likely to know more about the economy than IMF staffers. And for
programs to be implemented in an effective and sustainable manner there must be a commitment of the country
behind the program, based on a broad consensus. Such a consensus can only be arrived at through discussion-
the kind of open discussion that, in the past, the IMF has shunned. There needs to be an increasing conviction
that participation matters, that policies and programs cannot be imposed on countries but to be successful must
be ‘owned’ by them, that consensus building is essential, that policies and development strategies need to be
adapted to the situation in the country, that there should be a shift from ‘conditionality’ to ‘selectivity’, rewarding
countries that have proven track records for using funds well with more funds, trusting them to continue to make
good use of their funds, and providing them with strong incentives. Basically, the country needs to be put in the
driver’s seat.
Countries need to consider alternatives and, through democratic political processes, make these choices for
themselves. It should be- and it should have been- the task of the international economic institutions to provide
the countries the wherewithal to make these informed choices on their own, with an understanding of the
consequences and the risks of each. The essence of freedom is the right to make a choice- and to accept the
responsibility that comes with it.