The Washington Consensus revisited: a new structural economics perspective

Abstract

The Washington Consensus reform resulted in economic collapse and stagnation in many transition economies and “lost decades” in other developing countries in 1980s and 1990s. The paper provides a new structural economics perspective of such failures. The Washington Consensus reform failed to recognize that many firms in a transition economy were not viable in an open, competitive market because those industries went against the comparative advantages determined by the economy’s endowment structure. Their survival relied on the government’s protections and subsidies through various interventions and distortions. The Washington Consensus advised the government to focus their reforms on issues related to property rights, corporate governance, government interventions, and other issues that may obstruct a firm’s normal management. Without resolving the firms’ viability problem, such reforms led to the firms’ collapse and an unintended decline and stagnation of the economy in the transition process. This paper suggests that the viability assumption in neoclassical economics be relaxed when analyzing development and transition issues in socialist, transition, and developing economies.

Keywords:

• industrial policy
• economic development
• comparative economic systems
• transition economics

JEL Classification:

• L5
• O1
• P5

Notes

1. Certainly, a few economists had dissenting views: Stiglitz was a notable example. In his book Wither Socialism?, Stiglitz (1994) questioned the desirability of privatization and other basic tenets of the Washington Consensus. Based on the theories of information asymmetry, Stiglitz argues that the government should play an active role to overcome market failures. In a series of articles, Dewatripont and Roland (1992a, 1992b, 1995) also favor gradual reforms over due to the consideration of uncertainty and cost of compensation for losers in the transition process.

2. The package of policies in Williamson’s original definition includes fiscal discipline, redirection of public spending from indiscriminate subsidies towards broad-based provision of pro-growth, poverty-alleviating services, broadening the tax base, interest rate liberalization, competitive exchange rates, trade liberalization, uniform tariffs, liberalization of inward foreign direct investment, privatization of state enterprises, deregulation of market entry, prudent oversight of financial institutions, and legal protection of property rights. Subsequent to Williamson’s coining of this phrase, the term Washington Consensus has been used to refer to a strongly market-based approach, labeled as market fundamentalism or neoliberalism, in the public discourse, although Williamson himself opposed to this broader definition. In the paper, I refer Washington Consensus to the second, general definition. Responding to the transition experience, John Williamson proposed a much more nuanced definition which incorporates many of the criticisms in this paper (Williamson 2005).

3. There were some economists arguing for an evolutional, gradual approach to privatization in the transition. For example, Kornai (1990) argues that private property rights cannot be made to work by fiat in the transitional economies where entire generations are forced to forget the civic principles and values associated with private ownership and private rights, and become a mere imitation of the most refined legal and business forms of the leading capitalist countries. Kornai also believes, however, that private ownership is the foundation for a well-functioning market system and privatization is the only way to eliminate SOEs’ soft budget constraints.

4. The initial conditions that have been regarded as beneficial to China’s transition include high proportions of cheap rural labor, low social security subsidies, a large population of overseas Chinese, and a relatively decentralized economy that helped to achieve some short-term progress.

5. There were also economists who held China’s reform in high regard. They include Jefferson and Rawski (1995), McKinnon (1994), MacMillan and Naughton (1992), Naughton (1995), Singh (1991), Harrold (1992), Perkins (1988), Murrell (1991, 1992), Qian and Xu (1993) and Lau, Qian, and Roland (2000).

6. Dell’Anno and Villa (2013) find that the impact of contemporaneous speed of transition reforms on economic growth is negative, but becomes positive in the longer horizon among the FSUEE countries. However, the growth in China and Vietnam outperformed the best performing transition countries in FSUEE.

7. Poland’s economic record is the best among the countries of the FSUEE. However, Poland did not completely implement shock therapy. Although prices in Poland were liberalized, most of its large SOEs were not privatized (World Bank 1996; Dabrowski 2001).

8. Kornai (2006) argues that the political and economic transformation in institutions in Eastern European region was a success, however, he also acknowledged that a considerable portion of the population experienced deep economic troubles in the transition process.

9. According to the convention in modern economics, the studies following this approach should be referred as structural economics. The word “new” is added to distinguish these studies from those of structuralism, which was the first wave of developing thinking popular in post World War II, especially in Latin America.

10. The competitive advantage of a nation refers to a situation where domestic industries in a nation fulfill the following four conditions: (i) They intensively use the nation’s abundant and relatively inexpensive factors of production; (ii) Their products have large domestic markets; (iii) Each industry forms a cluster; and (iv), domestic market for each industry is competitive (Porter 1990). A country’s comparative advantage is the situation in which it produces a good or service at a lower opportunity cost than that of its competitors. The first condition for competitive advantage is the economy’s comparative advantage determined by the nations’ endowments. The third and the fourth conditions will hold only if the industries are consistent with the nation’s comparative advantage. Therefore, the four conditions can be reduced to two independent conditions: the comparative advantage and domestic market size. Among these two independent conditions, the comparative advantage is the most important because if an industry is the country’s comparative advantage, the industry’s product is competitive globally and will have a global market. That is why many of the richest countries in the world are very small (Lin and Ren 2007).

11. The comparative advantage was originally used to analyze the inter-industry trade across countries. Much trade today is of intra-industries. However, if we use production activities as units of observation, comparative advantage is also applicable to the analysis of intra-industry trade.

12. There could be many factors that affect the viability of a firm. In this paper, as well as in my other works, I use the term “non-viability” to describe the inability of normally managed firms to earn socially acceptable profits because of the violation of comparative advantage in their choices of industries and technologies.

13. The models based on increasing returns, such as Krugman (1981, 1987, 1991) and Matsuyama (1991), and coordination of investments, such as Murphy, Shleifer, and Vishny (1989), assume that the endowment structure of each country is identical, and, therefore, that firms will be viable in an undistorted, open, competitive market once the government helps the firms overcome market failure and escape the poor-equilibrium trap. Such models could be appropriate for considering the government’s role in assisting firms to compete with those in other countries in a similar stage of development. Such models are, however, inappropriate as a policy framework for developing countries that are attempting to catch up with developed countries because the endowment structures in developing and developed countries are different. With government’s help, a developing country might be able to set up firms in advanced capital-intensive industries that have economies of scale; however, because of the scarcity of human and physical capital, the cost of production in the developing country will be higher than that in a developed country. The firms will, therefore, still be nonviable in an undistorted, open, competitive market. As such, the government needs to support and protect the firms continuously after they have been set up.

14. The financial repression discussed by McKinnon (1973) and Shaw (1973) is a result of this strategy.

15. The excessive regulation and administrative control will cause many private activities to escape into informal sectors (de Soto 1987).

16. The soft budget constraint is a term coined by Kornai (1986), which became a popular research subject after the article by Dewatripont and Maskin (1995). According to Kornai, the soft budget constraint is a result of the paternalism of a socialist state; and, according to Dewatripont and Maskin, it is an endogenous phenomenon, arising from a time inconsistency problem. In Lin and Tan (1999) and Lin and Li (2008), I argue that the soft budget constraint arises from the policy burdens imposed on enterprises.

17. In the models of Olson (1982), Acemoglu, Johnson, and Robinson (2001, 2002, 2005), Grossman and Helpman (1996, 2001) and Engerman and Sokoloff (1997), government intervention, institutional distortions and rent seeking arise from the capture of government by powerful vested-interest élites. Logically, their models can explain some observed interventions and distortions, such as import quotas, tax subsidies, entry regulations, and so on. Their theories cannot, however, explain the existence of other important interventions and distortions – for example, the pervasiveness of public-owned enterprises in developing countries, which are against the interests of the powerful élites. Appendix 1 of Lin (2009) provides a formal model for the observed set of seemingly unrelated or even self-conflicting distortions and interventions in developing countries based on the need to support nonviable firms arising from the conflicts between the CAD strategy pursued by the government and the given endowment structure in the economy. However, once the government introduces a distortion, a group of vested interests will be created even if the distortion is created for noble purpose. The vested-interest argument could be appropriate for explaining the difficulty of removing distortions.

18. The difference in the shares of nonviable firms in the economy might explain why the shock therapy recommended by Sachs succeeded in Bolivia but not in the economies of Eastern Europe and the former Soviet Union. Bolivia is a poor, small economy; therefore, the resources that the government could mobilize to subsidize the nonviable firms were small and the share of nonviable firms in the economy was also relatively small. Stiglitz (1998) questioned the universal applicability of the Washington Consensus. He pointed out that it advocated use of a small set of instruments – including macroeconomic stability, liberalized trade and privatization – to achieve a relatively narrow goal of economic growth. He encouraged governments to use a broader set of instruments – such as financial regulations and competition policy – to achieve a broader set of goals, including sustainable development, equity of income distribution, and so on. Stiglitz’s arguments are based on information asymmetry and the needs for government to overcome market failures. However, he did not discuss how to deal with the issue of nonviable firms in developing and transitional economies and the implications of nonviability for choices of transition path and policies.

19. When reform started at the end of 1978, the government originally proposed to raise the agricultural procurement prices, to liberalize rural market fairs, and to reduce the size of production team of 20–30 households to voluntarily formed production group of 3–5 households, but explicitly prohibited the replacement of production team system with an individual household-based farming system. However, a production team in a poor village in Fengyang County, Anhui Province secretly leased the collective owned land to individual households in the team in the fall of 1978 and harvested a bump increase in outputs in 1979. Seeing the effects of individual household-based farming system, the government changed its policy and endorsed the individual household-based farming system as a new direction of farming system reform (Lin 1992). Initially, the collectively-owned land was leased to farm households for one to three years, extended to 15 years in 1985, and further extended to 30 years in 1994. The farm household was obliged to deliver certain amounts of agricultural produce at the government-set prices to fulfill its quota obligation until the late 1990s.

20. The SOE reform proceeded from the profit-retention system in 1979, the contract-responsibility system in 1986, and the modern corporation system from the 1990s to now. Each system was experimented in a small group of enterprises first before that system was extended nationwide (Lin, Cai, and Li 2001; Lin 2012b).

21. The TVE was another institutional innovation by the peasants in China during the transition process. After the HRS reform, farmers obtained a substantial amount of residuals and saw profitable investment opportunities in consumer-products sector. However, due to the ideological reason at that time, the form of private enterprise was prohibited and the farmers used the collective TVE as an alternative to tap into the profitable opportunity. The government initially put many restrictions on the operation of TVEs for fear of TVEs’ competition with SOEs for credits, resources, and markets. Only after the government was convinced by the evidences that the TVE was good for increasing farmers’ income and for solving the shortages in the urban markets, did the government give green light to the development of TVEs in rural China (Lin, Cai, and Li 2003).

22. Besides the viability problem, the SOEs in China have an additional problem of social burdens. Before the economic transition, the investment in heavy industry provided limited employment opportunities. The government was responsible for urban employment and usually assigned several workers to a job, resulting in labor redundancy in SOEs. The workers also received low wages, which were enough for covering current consumption only. Before the transition, SOEs remitted all their revenues to the government, and the government used fiscal appropriation to cover SOEs’ wages, pensions of retired workers, and other expenditures. Therefore, the labor redundancy and the pension expenditure were not burdens on SOEs. After the reforms, SOEs started to be responsible for their workers’ wages and retirement pensions. The newly established TVEs, joint ventures, and other nonstate firms are in sectors that are consistent with China’s comparative advantage and they do not have the problem of labor redundancy and unfunded pensions for retired workers. I call the issue arising from the viability problem the SOEs’ “strategic burden” and the additional cost arising from labor redundancy and pension expenditures the SOEs’ “social burden.” Together they constitute the SOEs’ “policy burdens.” As long as these policy burdens exist, the government is responsible for the firms’ losses and the soft budget constraint cannot be eliminated (Lin and Tan 1999). There is a consensus in China about the necessity and the way to eliminate the social burdens. Therefore, the remaining issue is how to solve the strategic burden.