http://www.tnr.com/041700/stiglitz041700.html

What I learned at the world economic crisis.
The Insider

By JOSEPH STIGLITZ
Issue date: 04.17.00
Post date: 04.06.00
(Copyright 2000, The New Republic)

Next week's meeting of the International Monetary Fund will bring to
Washington, D.C., many of the same demonstrators who trashed the World Trade
Organization in Seattle last fall. They'll say the IMF is arrogant. They'll
say the IMF doesn't really listen to the developing countries it is supposed
to help. They'll say the IMF is secretive and insulated from democratic
accountability. They'll say the IMF's economic "remedies" often make things
worse--turning slowdowns into recessions and recessions into depressions.
And they'll have a point. I was chief economist at the World Bank from 1996
until last November, during the gravest global economic crisis in a
half-century. I saw how the IMF, in tandem with the U.S. Treasury
Department, responded. And I was appalled.
The global economic crisis began in Thailand, on July 2, 1997. The countries
of East Asia were coming off a miraculous three decades: incomes had soared,
health had improved, poverty had fallen dramatically. Not only was literacy
now universal, but, on international science and math tests, many of these
countries outperformed the United States. Some had not suffered a single
year of recession in 30 years.


But the seeds of calamity had already been planted. In the early '90s, East
Asian countries had liberalized their financial and capital markets--not
because they needed to attract more funds (savings rates were already 30
percent or more) but because of international pressure, including some from
the U.S. Treasury Department. These changes provoked a flood of short-term
capital--that is, the kind of capital that looks for the highest return in
the next day, week, or month, as opposed to long-term investment in things
like factories. In Thailand, this short-term capital helped fuel an
unsustainable real estate boom. And, as people around the world (including
Americans) have painfully learned, every real estate bubble eventually
bursts, often with disastrous consequences. Just as suddenly as capital
flowed in, it flowed out. And, when everybody tries to pull their money out
at the same time, it causes an economic problem. A big economic problem.
The last set of financial crises had occurred in Latin America in the 1980s,
when bloated public deficits and loose monetary policies led to runaway
inflation. There, the IMF had correctly imposed fiscal austerity (balanced
budgets) and tighter monetary policies, demanding that governments pursue
those policies as a precondition for receiving aid. So, in 1997 the IMF
imposed the same demands on Thailand. Austerity, the fund's leaders said,
would restore confidence in the Thai economy. As the crisis spread to other
East Asian nations--and even as evidence of the policy's failure
mounted--the IMF barely blinked, delivering the same medicine to each ailing
nation that showed up on its doorstep.
I thought this was a mistake. For one thing, unlike the Latin American
nations, the East Asian countries were already running budget surpluses. In
Thailand, the government was running such large surpluses that it was
actually starving the economy of much-needed investments in education and
infrastructure, both essential to economic growth. And the East Asian
nations already had tight monetary policies, as well: inflation was low and
falling. (In South Korea, for example, inflation stood at a very respectable
four percent.) The problem was not imprudent government, as in Latin
America; the problem was an imprudent private sector--all those bankers and
borrowers, for instance, who'd gambled on the real estate bubble.
Under such circumstances, I feared, austerity measures would not revive the
economies of East Asia--it would plunge them into recession or even
depression. High interest rates might devastate highly indebted East Asian
firms, causing more bankruptcies and defaults. Reduced government
expenditures would only shrink the economy further.
So I began lobbying to change the policy. I talked to Stanley Fischer, a
distinguished former Massachusetts Institute of Technology economics
professor and former chief economist of the World Bank, who had become the
IMF's first deputy managing director. I met with fellow economists at the
World Bank who might have contacts or influence within the IMF, encouraging
them to do everything they could to move the IMF bureaucracy.
Convincing people at the World Bank of my analysis proved easy; changing
minds at the IMF was virtually impossible. When I talked to senior officials
at the IMF--explaining, for instance, how high interest rates might increase
bankruptcies, thus making it even harder to restore confidence in East Asian
economies--they would at first resist. Then, after failing to come up with
an effective counterargument, they would retreat to another response: if
only I understood the pressure coming from the IMF board of executive
directors--the body, appointed by finance ministers from the advanced
industrial countries, that approves all the IMF's loans. Their meaning was
clear. The board's inclination was to be even more severe; these people were
actually a moderating influence. My friends who were executive directors
said they were the ones getting pressured. It was maddening, not just
because the IMF's inertia was so hard to stop but because, with everything
going on behind closed doors, it was impossible to know who was the real
obstacle to change. Was the staff pushing the executive directors, or were
the executive directors pushing the staff? I still do not know for certain.
Of course, everybody at the IMF assured me they would be flexible: if their
policies really turned out to be overly contractionary, forcing the East
Asian economies into deeper recession than necessary, then they would
reverse them. This sent shudders down my spine. One of the first lessons
economists teach their graduate students is the importance of lags: it takes
twelve to 18 months before a change in monetary policy (raising or lowering
interest rates) shows its full effects. When I worked in the White House as
chairman of the Council of Economic Advisers, we focused all our energy on
forecasting where the economy would be in the future, so we could know what
policies to recommend today. To play catch-up was the height of folly. And
that was precisely what the IMF officials were proposing to do.
I shouldn't have been surprised. The IMF likes to go about its business
without outsiders asking too many questions. In theory, the fund supports
democratic institutions in the nations it assists. In practice, it
undermines the democratic process by imposing policies. Officially, of
course, the IMF doesn't "impose" anything. It "negotiates" the conditions
for receiving aid. But all the power in the negotiations is on one side--the
IMF's--and the fund rarely allows sufficient time for broad
consensus-building or even widespread consultations with either parliaments
or civil society. Sometimes the IMF dispenses with the pretense of openness
altogether and negotiates secret covenants.
When the IMF decides to assist a country, it dispatches a "mission" of
economists. These economists frequently lack extensive experience in the
country; they are more likely to have firsthand knowledge of its five-star
hotels than of the villages that dot its countryside. They work hard, poring
over numbers deep into the night. But their task is impossible. In a period
of days or, at most, weeks, they are charged with developing a coherent
program sensitive to the needs of the country. Needless to say, a little
number-crunching rarely provides adequate insights into the development
strategy for an entire nation. Even worse, the number-crunching isn't always
that good. The mathematical models the IMF uses are frequently flawed or
out-of-date. Critics accuse the institution of taking a cookie-cutter
approach to economics, and they're right. Country teams have been known to
compose draft reports before visiting. I heard stories of one unfortunate
incident when team members copied large parts of the text for one country's
report and transferred them wholesale to another. They might have gotten
away with it, except the "search and replace" function on the word processor
didn't work properly, leaving the original country's name in a few places.
Oops.
It's not fair to say that IMF economists don't care about the citizens of
developing nations. But the older men who staff the fund--and they are
overwhelmingly older men--act as if they are shouldering Rudyard Kipling's
white man's burden. IMF experts believe they are brighter, more educated,
and less politically motivated than the economists in the countries they
visit. In fact, the economic leaders from those countries are pretty
good--in many cases brighter or better-educated than the IMF staff, which
frequently consists of third-rank students from first-rate universities.
(Trust me: I've taught at Oxford University, MIT, Stanford University, Yale
University, and Princeton University, and the IMF almost never succeeded in
recruiting any of the best students.) Last summer, I gave a seminar in China
on competition policy in telecommunications. At least three Chinese
economists in the audience asked questions as sophisticated as the best
minds in the West would have asked.
As time passed, my frustration mounted. (One might have thought that since
the World Bank was contributing literally billions of dollars to the rescue
packages, its voice would be heard. But it was ignored almost as resolutely
as the people in the affected countries.) The IMF claimed that all it was
asking of the East Asian countries was that they balance their budgets at a
time of recession. All? Hadn't the Clinton administration just fought a
major battle with Congress to stave off a balanced-budget amendment in this
country? And wasn't the administration's key argument that, in the face of
recession, a little deficit spending might be necessary? This is what I and
most other economists had been teaching our graduate students for 60 years.
Quite frankly, a student who turned in the IMF's answer to the test question
"What should be the fiscal stance of Thailand, facing an economic downturn?"
would have gotten an F.
As the crisis spread to Indonesia, I became even more concerned. New
research at the World Bank showed that recession in such an ethnically
divided country could spark all kinds of social and political turmoil. So in
late 1997, at a meeting of finance ministers and central-bank governors in
Kuala Lumpur, I issued a carefully prepared statement vetted by the World
Bank: I suggested that the excessively contractionary monetary and fiscal
program could lead to political and social turmoil in Indonesia. Again, the
IMF stood its ground. The fund's managing director, Michel Camdessus, said
there what he'd said in public: that East Asia simply had to grit it out, as
Mexico had. He went on to note that, for all of the short-term pain, Mexico
emerged from the experience stronger.
But this was an absurd analogy. Mexico hadn't recovered because the IMF
forced it to strengthen its weak financial system, which remained weak years
after the crisis. It recovered because of a surge of exports to the United
States, which took off thanks to the U.S. economic boom, and because of
nafta. By contrast, Indonesia's main trading partner was Japan--which was
then, and still remains, mired in the doldrums. Furthermore, Indonesia was
far more politically and socially explosive than Mexico, with a much deeper
history of ethnic strife. And renewed strife would produce massive capital
flight (made easy by relaxed currency-flow restrictions encouraged by the
IMF). But none of these arguments mattered. The IMF pressed ahead, demanding
reductions in government spending. And so subsidies for basic necessities
like food and fuel were eliminated at the very time when contractionary
policies made those subsidies more desperately needed than ever.
By January 1998, things had gotten so bad that the World Bank's vice
president for East Asia, Jean Michel Severino, invoked the dreaded r-word
("recession") and d-word ("depression") in describing the economic calamity
in Asia. Lawrence Summers, then deputy treasury secretary, railed against
Severino for making things seem worse than they were, but what other way was
there to describe what was happening? Output in some of the affected
countries fell 16 percent or more. Half the businesses in Indonesia were in
virtual bankruptcy or close to it, and, as a result, the country could not
even take advantage of the export opportunities the lower exchange rates
provided. Unemployment soared, increasing as much as tenfold, and real wages
plummeted--in countries with basically no safety nets. Not only was the IMF
not restoring economic confidence in East Asia, it was undermining the
region's social fabric. And then, in the spring and summer of 1998, the
crisis spread beyond East Asia to the most explosive country of all--Russia.
The calamity in Russia shared key characteristics with the calamity in East
Asia--not least among them the role that IMF and U.S. Treasury policies
played in abetting it. But, in Russia, the abetting began much earlier.
Following the fall of the Berlin Wall, two schools of thought had emerged
concerning Russia's transition to a market economy. One of these, to which I
belonged, consisted of a melange of experts on the region, Nobel Prize
winners like Kenneth Arrow and others. This group emphasized the importance
of the institutional infrastructure of a market economy--from legal
structures that enforce contracts to regulatory structures that make a
financial system work. Arrow and I had both been part of a National Academy
of Sciences group that had, a decade earlier, discussed with the Chinese
their transition strategy. We emphasized the importance of fostering
competition--rather than just privatizing state-owned industries--and
favored a more gradual transition to a market economy (although we agreed
that occasional strong measures might be needed to combat hyperinflation).
The second group consisted largely of macroeconomists, whose faith in the
market was unmatched by an appreciation of the subtleties of its
underpinnings--that is, of the conditions required for it to work
effectively. These economists typically had little knowledge of the history
or details of the Russian economy and didn't believe they needed any. The
great strength, and the ultimate weakness, of the economic doctrines upon
which they relied is that the doctrines are--or are supposed to
be--universal. Institutions, history, or even the distribution of income
simply do not matter. Good economists know the universal truths and can look
beyond the array of facts and details that obscure these truths. And the
universal truth is that shock therapy works for countries in transition to a
market economy: the stronger the medicine (and the more painful the
reaction), the quicker the recovery. Or so the argument goes.
Unfortunately for Russia, the latter school won the debate in the Treasury
Department and in the IMF. Or, to be more accurate, the Treasury Department
and the IMF made sure there was no open debate and then proceeded blindly
along the second route. Those who opposed this course were either not
consulted or not consulted for long. On the Council of Economic Advisers,
for example, there was a brilliant economist, Peter Orszag, who had served
as a close adviser to the Russian government and had worked with many of the
young economists who eventually assumed positions of influence there. He was
just the sort of person whose expertise Treasury and the IMF needed. Yet,
perhaps because he knew too much, they almost never consulted him.
We all know what happened next. In the December 1993 elections, Russian
voters dealt the reformers a huge setback, a setback from which they have
yet really to recover. Strobe Talbott, then in charge of the noneconomic
aspects of Russia policy, admitted that Russia had experienced "too much
shock and too little therapy." And all that shock hadn't moved Russia toward
a real market economy at all. The rapid privatization urged upon Moscow by
the IMF and the Treasury Department had allowed a small group of oligarchs
to gain control of state assets. The IMF and Treasury had rejiggered
Russia's economic incentives, all right--but the wrong way. By paying
insufficient attention to the institutional infrastructure that would allow
a market economy to flourish--and by easing the flow of capital in and out
of Russia--the IMF and Treasury had laid the groundwork for the oligarchs'
plundering. While the government lacked the money to pay pensioners, the
oligarchs were sending money obtained by stripping assets and selling the
country's precious national resources into Cypriot and Swiss bank accounts.
The United States was implicated in these awful developments. In mid-1998,
Summers, soon to be named Robert Rubin's successor as secretary of the
treasury, actually made a public display of appearing with Anatoly Chubais,
the chief architect of Russia's privatization. In so doing, the United
States seemed to be aligning itself with the very forces impoverishing the
Russian people. No wonder antiAmericanism spread like wildfire.
At first, Talbott's admission notwithstanding, the true believers at
Treasury and the IMF continued to insist that the problem was not too much
therapy but too little shock. But, through the mid-'90s, the Russian economy
continued to implode. Output plummeted by half. While only two percent of
the population had lived in poverty even at the end of the dismal Soviet
period, "reform" saw poverty rates soar to almost 50 percent, with more than
half of Russia's children living below the poverty line. Only recently have
the IMF and Treasury conceded that therapy was undervalued--though they now
insist they said so all along.
Today, Russia remains in desperate shape. High oil prices and the
long-resisted ruble devaluation have helped it regain some footing. But
standards of living remain far below where they were at the start of the
transition. The nation is beset by enormous inequality, and most Russians,
embittered by experience, have lost confidence in the free market. A
significant fall in oil prices would almost certainly reverse what modest
progress has been made.
East Asia is better off, though it still struggles, too. Close to 40 percent
of Thailand's loans are still not performing; Indonesia remains deeply mired
in recession. Unemployment rates remain far higher than they were before the
crisis, even in East Asia's best-performing country, Korea. IMF boosters
suggest that the recession's end is a testament to the effectiveness of the
agency's policies. Nonsense. Every recession eventually ends. All the IMF
did was make East Asia's recessions deeper, longer, and harder. Indeed,
Thailand, which followed the IMF's prescriptions the most closely, has
performed worse than Malaysia and South Korea, which followed more
independent courses.
I was often asked how smart--even brilliant--people could have created such
bad policies. One reason is that these smart people were not using smart
economics. Time and again, I was dismayed at how out-of-date--and how
out-of-tune with reality--the models Washington economists employed were.
For example, microeconomic phenomena such as bankruptcy and the fear of
default were at the center of the East Asian crisis. But the macroeconomic
models used to analyze these crises were not typically rooted in
microfoundations, so they took no account of bankruptcy.
But bad economics was only a symptom of the real problem: secrecy. Smart
people are more likely to do stupid things when they close themselves off
from outside criticism and advice. If there's one thing I've learned in
government, it's that openness is most essential in those realms where
expertise seems to matter most. If the IMF and Treasury had invited greater
scrutiny, their folly might have become much clearer, much earlier. Critics
from the right, such as Martin Feldstein, chairman of Reagan's Council of
Economic Advisers, and George Shultz, Reagan's secretary of state, joined
Jeff Sachs, Paul Krugman, and me in condemning the policies. But, with the
IMF insisting its policies were beyond reproach--and with no institutional
structure to make it pay attention--our criticisms were of little use. More
frightening, even internal critics, particularly those with direct
democratic accountability, were kept in the dark. The Treasury Department is
so arrogant about its economic analyses and prescriptions that it often
keeps tight--much too tight--control over what even the president sees.
Open discussion would have raised profound questions that still receive very
little attention in the American press: To what extent did the IMF and the
Treasury Department push policies that actually contributed to the increased
global economic volatility? (Treasury pushed liberalization in Korea in 1993
over the opposition of the Council of Economic Advisers. Treasury won the
internal White House battle, but Korea, and the world, paid a high price.)
Were some of the IMF's harsh criticisms of East Asia intended to detract
attention from the agency's own culpability? Most importantly, did
America--and the IMF--push policies because we, or they, believed the
policies would help East Asia or because we believed they would benefit
financial interests in the United States and the advanced industrial world?
And, if we believed our policies were helping East Asia, where was the
evidence? As a participant in these debates, I got to see the evidence.
There was none.
Since the end of the cold war, tremendous power has flowed to the people
entrusted to bring the gospel of the market to the far corners of the globe.
These economists, bureaucrats, and officials act in the name of the United
States and the other advanced industrial countries, and yet they speak a
language that few average citizens understand and that few policymakers
bother to translate. Economic policy is today perhaps the most important
part of America's interaction with the rest of the world. And yet the
culture of international economic policy in the world's most powerful
democracy is not democratic.
This is what the demonstrators shouting outside the IMF next week will try
to say. Of course, the streets are not the best place to discuss these
highly complex issues. Some of the protesters are no more interested in open
debate than the officials at the IMF are. And not everything the protesters
say will be right. But, if the people we entrust to manage the global
economy--in the IMF and in the Treasury Department--don't begin a dialogue
and take their criticisms to heart, things will continue to go very, very
wrong. I've seen it happen.
JOSEPH STIGLITZ is professor of economics at Stanford University (on leave)
and a senior fellow at the Brookings Institution. From 1997 to 2000, he was
chief economist and vice president of the World Bank. He served on the
president's Council of Economic Advisers from 1993 to 1997.






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