Central Banks Are Wrong about Rate Cuts

In my naivete, I was at first surprised that “the Washington consensus” carried such weight. I knew it was controversial, of course, but I had not realized that it had become such a rhetorical trope for an overall point of view. And like many such phrases, the use of the phrase in conversation had become disconnected from the original meaning of the term.

For those who want to dig into this issue, and how evidence and thinking about it has evolved with time, the Summer 2021 issue of the Journal of Economic Perspectives has a four-paper symposium on the subject. (Full disclosure: I have worked as Managing Editor of JEP since the first issue back in 1987. All articles in JEP back to the first issue are freely available online.) The first essay, by Michael Spence, sets the tone with “Some Thoughts on the Washington Consensus and Subsequent Global Development Experience.” Spence starts with a useful reminder of how the “Washington consensus” originally emerged and what it actually said. Spence begins:

In 1989, policymakers around the world were struggling to come to grips with the debt crisis and slow growth that had plagued developing economies during much of the 1980s, especially nations in Latin America and sub-Saharan Africa. The International Institute of Economics (now the Peterson Institute of International Economics) held a conference discussing the economic and debt situation, mostly focused on Latin American countries. The conference was run by John Williamson (who died in April 2021), a senior fellow at the institute who specialized in topics related to international capital flows, exchange rates, and development. To focus the conference discussion, Williamson (1990) wrote a background paper that began: “No statement about how to deal with the debt crisis in Latin America would be complete without a call for the debtors to fulfill their part of the proposed bargain by ‘setting their houses in order,’ ‘undertaking policy reforms,’ or ‘submitting to strong conditionality.’ The question posed in this paper is what such phrases mean, and especially what they are generally interpreted as meaning in Washington.”

Williamson (1990) described what he saw as a convergence of opinion about ten policies areas designed to promote stability and economic development that he felt had emerged during the 1980s. With hindsight, it appears that one of the principal targets was bouts of instability in inflation, public finances, and the balance of payments. If one asks who the consenting parties are in this “consensus,” the answer appears to include the US Treasury, the International Monetary Fund and World Bank, think tanks with related agendas, to some extent academia, and over time Latin American governments who came to understand the destructive power of macroeconomic instability with respect to growth. It is noteworthy that in the mid-1990s, inflation in a wide range of developing countries dropped substantially and stayed there.

A few points here are worth emphasizing. In discussions of the economies of Latin America, the 1980s are commonly referred to as the “lost decade” because of the mixture of slow growth, inflation and hyperinflation, and debt crises. The “Washington consensus” was never a broad strategy for economic reform or an overall agenda for economic development and growth. It was a discussion of what governments needed to do to qualify for a debt relief or debt reservicing agreement. Moreover, it was a list of the points that seemed to Williamson to command broad agreement–not the points that were more controversial. In the original 1990 essay, Williamson divided his discussion into 10 areas, but it was not until some years later that he turned them into a short list. Spence reproduces Williamson’s list:

1. Budget deficits . . . should be small enough to be financed without recourse to the inflation tax.

2. Public expenditure should be redirected from politically sensitive areas that receive more resources than their economic return can justify . . . toward neglected fields with high economic returns and the potential to improve income distribution, such as primary education and health, and infrastructure.

3.Tax reform . . . so as to broaden the tax base and cut marginal tax rates.

4. Financial liberalization, involving an ultimate objective of market-determined interest rates.

5. A unified exchange rate at a level sufficiently competitive to induce a rapid growth in nontraditional exports.

6. Quantitative trade restrictions to be rapidly replaced by tariffs, which would be progressively reduced until a uniform low rate in the range of 10 to 20 percent was achieved.

7. Abolition of barriers impeding the entry of FDI (foreign direct investment).

8. Privatization of state enterprises.

9. Abolition of regulations that impede the entry of new firms or restrict competition.

10. The provision of secure property rights, especially to the informal sector.

There are lots of things one can say about this list, but perhaps the first one is that, when countries are being told what they need to do for debt relief, calling it the “Washington consensus” is just terrible public relations. Williamson wrote in a 2004 essay: “I labeled this the ‘Washington Consensus,’ sublimely oblivious to the thought that I might be coining either an oxymoron or a battle cry for ideological disputes for the next coup.”

But let’s set aside the other arguments for a moment and consider a more basic question: Did countries that followed the Washington consensus recommendations more closely tend on average to have better economic outcomes? The answer seems to be “yes.”

In the Summer 2021 issue of JEP, Anusha Chari, Peter Blair Henry, and Hector Reyes discuss “The Baker Hypothesis: Stabilization, Structural Reforms, and Economic Growth.” (Then-Treasury Secretary James Baker laid out some of the basics of what came to be called the “Washington consensus” a few years before Williamson bestowed the actual label.) They look at the specific years that countries adopted various Washington consensus reforms, and what happened before and after. They write:

First, in the ten-year period after stabilizing high inflation, the average growth rate of real GDP in EMDEs [emerging market and developing economies] is 2.6 percentage points higher than in the prior ten-year period. Second, the corresponding growth increase for trade liberalization episodes is 2.66 percentage points. Third, in the decade after opening their capital markets to foreign equity investment, the spread between EMDEs average cost of equity capital and that of the US declines by 240 basis points.

Also in the JEP symposium, Ilan Goldfajn, Lorenza Martínez, and Rodrigo O. Valdés find broadly similar results of a positive effect in “Washington Consensus in Latin America: From Raw Model to Straw Man,” while Belinda Archibong,, Brahima Coulibaly, and Ngozi Okonjo-Iweala also finde a positive effect in  “Washington Consensus Reforms and Lessons for Economic Performance in Sub-Saharan Africa.”

 Some recent research papers in other journals agree with the general finding. For example, Kevin B. Grier and Robin M. Grier published “The Washington consensus works: Causal effects of reform, 1970-2015,” in the Journal of Comparative Economics (March 2021, 49:1, pp. 59-72).  William Easterly, who has been a critic of the “Washington consensus” in the past, offers an update and some new thinking in “In Search of Reforms for Growth New Stylized Facts on Policy and Growth Outcomes” (Cato Institute, Research Briefs #215, May 20, 2020, and NBER Working Paper 26318, September 2019).

But as a number of the JEP papers are quick to point out, the fact that the Washington consensus was a generally sensible set of policy recommendations does not address many of the underlying concerns directly.

1. The major global growth success stories since the formulation of the Washington consensus have happened in Asia: China, India, and others. These countries have followed some aspects of the Washington consensus but clearly not others (like commitments to privatization, financial liberalization, floating exchange rates, and free trade). The Washington consensus doesn’t seem especially useful in thinking about what caused growth in Asian economies to take off.
   
   
2. In the urgent push of resolving debt crises, some parts of the Washington consensus often got lost in the shuffle: in particular, the #2 recommendation about redistributing public resources “toward neglected fields with high economic returns and the potential to improve income distribution, such as primary education and health, and infrastructure” seemed to be left out when debt relief agreements were actually reached. Indeed, the debt relief agreements sometimes involved cutting government spending in those areas.
   
   
3. The Washington consensus put too little emphasis on real-world transition problems. When a certain domestic industry is opened up to international trade, and many of the local producers are driven out of business, what is the government to do? When a large state-owned company is privatized and becomes a large unregulated private monopoly instead, what is the government to do? Praying to the gods of “it will be all right in the long run” is not a useful answer.
   
   
4. In general, the Washington consensus seems to neglect the need for broad political and social buy-in on reforms, and thus feels like a mandate handed down from on high.
   
   
5. Some topics that seem important both for growth don’t seem to be explicitly addressed in the Washington consensus. It’s generally believed that economic growth comes primarily from a society that has make use of new technologies developed elsewhere and create new technologies of its own. Some bits and pieces of the Washington consensus list can be interpreted in these terms, but it’s not an explicit focus.
   
   
6. Some topics that seem important for social cohesion don’t seem to be addressed. For example, there is no mention of reducing corruption or crime, improving the environment, or an explicit goal of reducing inequality.

It would of course be a little silly to treat a set of reforms partially carried out by some countries in the late 1980s and into the 1990s as the sole factors determining economic performance since then. Thus, along with these kinds of concerns, Archibong, Coulibaly, and Okonjo-Iweala point out in their discussion of Africa’s growth experience that there is a general surge in Africa’s growth starting around 2000. One reason for that surge was growth in democracy: they discuss the “wave of democratization in the 1990s, with the number of countries that held multi-party elections increasing from just two (Botswana and Mauritius) before 1989 to 44 of 48 countries—or 92 percent of sub-Saharan Africa—by mid-2003 (Lynch and Crawford 2011). This had the effect of encouraging investment in infrastructure and in pro-poor policies.” In looking at the economic successes of Africa in the last two decades, they write:

[I]t is not obvious that the market-oriented reforms emphasized by international financial institutions are the best or only route to successful economic development. Skeptics of market-oriented reforms in Africa point out that in many successful development efforts around the world, including many countries across Asia, governments played a prominent role for much of the critical phase of their economic development. Historically, many of today’s developed economies did not fully embrace free market economies in the earlier phases of their economic development, which instead involved substantial state involvement including industrial subsidies and infant industry protection (for a discussion of the development experience of today’s advanced economies, one useful starting point is Chang 2002). In Africa, many of these same practices used at other places and times were frowned upon by proponents of market-oriented policies. But before countries of sub-Saharan Africa fell into the debt crisis of the 1980s, many of them had experienced success in the period immediately post-independence in the 1960s and 1970s (Mkandawire 1999). Indeed, some of the policies that were abandoned in favor of market-oriented reforms had rational, development-motivated justifications.

More broadly, what seems to have happened is that, among both supporters and detractors, the “Washington consensus” became a phrase that was used to refer to a recommendation for largely unfettered markets and limited government. This is why Goldfajn, Martínez, and Valdés, in their essay about Latin America, refer to the argument as a “straw man.” They write:

In current public policy debates in Latin America, controversy over “neoliberalism” dwarfs interest in the Washington Consensus. Neoliberalism is the straw man most commonly held up as responsible for Latin America’s economic problems. According to our calculations using the Google Books Ngram Viewer, books published in 2019 in Spanish had 70 times more references to “neoliberalism” than to the “Washington Consensus.”

But neoliberalism is not a clearly defined concept in economics. In public discussion, neoliberalism is narrowly associated with a laissez-faire view (à la Hayek) and perhaps also with extreme monetarism (à la Friedman), and it is sometimes equated with rather orthodox and pro-market reforms. Neoliberalism has also been identified with policies that disregard some relevant aspects of development, such as inequality and poverty, and neglect any role for the state. More importantly for the issues discussed here, critics have sometimes caricatured the Washington Consensus as a neoliberal manifesto. As described by Thorsen (2010, p. 3), neoliberalism has become “a generic term of deprecation to describe almost any economic and political development deemed undesirable.” The Washington Consensus should not be mechanically associated with this neoliberal straw man.

As shown in this paper, the Washington Consensus was a list of recommendations that was partially adopted with mixed results, some of which were satisfactory and others clearly not. In our view, without some subset of the Washington Consensus policies, it would have been difficult, if not impossible, to achieve macroeconomic stability and to recover access to foreign financing in the late 1980s and early 1990s. The main risk in Latin America at present is that economic populism will gain ground and policymakers will discard the Washington Consensus policies altogether.

One lesson that should have been learned in the 1970s and 1980s, and that gave birth to the “Washington consensus” idea,” is that extreme macroeconomic stability is not good for growth or the standard of living.