What is the Washington Consensus?

The Washington Consensus for development was a reform list imposed on recipients of IMF and World Bank structural adjustment loans in Africa and Latin America in the late 80s. It is one of the most common reference points for ‘neoliberalism’. Countries that received these loans suffered horribly, and yet we continue to espouse much of the Washington Consensus in development economics today. How can that be right?

It’s right because the failures surround the practicalities of trading with Europe and America and with the specifics of austerity and currency devaluation in Africa and Latin America at the time. They are failures of the structural adjustment lending programs not the Washington consensus itself. Certainly things were bungled and the consensus has had to change, but the theory behind most of the consensus is very sound. Those keen to see development into the future would do well to understand the shortcomings of the consensus rather than avoiding it altogether. I’ll try to explain.

First, what is in the consensus? Below is the list with some explanatory points.

•  Shifting public expenditure away from consumption spending, such as fuel subsidies and cash transfers (i.e. the Venezuelan approach to poverty alleviation), towards investments in productivity and social mobility like infrastructure, education and public transport. The latter are slower to affect poverty level but much more effective in the long run because they increase human capital, lower transaction costs, make access to jobs and markets cheaper and make it easier for people to establish businesses.
• Privatise public assets, especially businesses and utilities. There are two reasons for this. First, publically controlled companies in underdeveloped countries tend to succumb to corruption. Competitive pressure makes corruption difficult. Second, private companies don’t have moral hazard, so they tend to have greater pressure to cut costs and deliver a lean product. Note that the sectors in question don’t need to be deregulated. For example, the system NSW is using to privatise its poles and wires while maintaining regulation of the price people can actually be charged for electricity is a case of privatisation with regulation. This is distinct from say, the UK rail privatisation, which resulted in massive price increases. This is arguably inefficient because while railways now make profits transactions costs are high. A tax financed system that leverages the lower transaction costs that arise out of an affordable and effective transit network to raise revenues may well be more efficient and is certainly better for social mobility. Note that mainstream and neoclassical economics both enshrine a strong role for government in enhancing equity and ensuring social mobility.
• Be open to trade and especially foreign direct investment (though note, not so much hot capital flows as business investment). Openness to trade is hugely important for exposing domestic firms to competition. Without competition, corruption in the form of oligarchy is a very real possibility. Firms have captured markets they grow wealthy off and then they use they wealth to establish close political links to inhibit change. Consumers (i.e. everyone) suffers. Prime examples are Japan, South Korea and China, and the US in certain protected sectors (notably agriculture). Competition also forces firms to increase their productivity, delivery better, lower cost products, to survive. This improves consumer welfare. The argument that foreign competition harms domestic firms fails to realise that foreign firms pay taxes domestically and employ domestic labour that pays taxes domestically. 
• Deregulate markets, especially bureaucratic controls on business activity. Red tape is a huge avenue for corruption and graft. Markets are good at allocating resources efficiently. Where social protection and equity considerations suggest that a pure market outcome would be bad try to intervene pre- or post-market rather than directly into the market. For example, a marketing board for farm produce is a market intervention—you are setting the price. Worse, bureaucrats are involved with strong incentives for corruption. Instead, you can intervene pre-market by providing infrastructure to reduce farmer’s costs of reaching market to sell produce and purchase farm products, or by providing education to farmers to help them increase their productivity, or by facilitating the emergence of efficient micro-credit facilities. To assist those urban workers who need the cheap food you can lower tariffs to allow cheap food imports, improve logistics so that food can be transported and stored more cheaply and thereby make cheaper food available in low seasons, or provide lump sum transfers to very poor urban workers. The key is to avoid possibilities for graft and limit the ability of the market to allocate resources where possible. This is quite different from say, banning trade unions.
• Broaden the tax base and use indirect taxation. Because of the large informal sectors and limited IT infrastructure in most developing countries, levelling direct taxes is very difficult. Because foreign direct investment is critical for capital deepening and job growth, corporate taxation is risky. And because trade is crucial for lower and middle income countries involved in the value chain of production, tariffs aren’t an option for revenue-raising. As such, one of the few options available is indirect taxation in the form of GST, luxury tax, utility charges, gift taxes and estate taxes. There is obviously not great from either a revenue raising or equity standpoint, and there is a large literature own when and how to move to more progressive approaches to wealth redistribution.
• One of the principle criticisms of the original Washington consensus was that it was entirely economic and didn’t consider political issues like rampant capture of political institutions. Since that time mainstream development economics has come to focus much more heavily on institutional parametres to development. This is a very rich area and hard to summarise concisely so I won’t bother here. Maybe in a future post. For anyone keen to read more Acemoglu and Robinson Why Nations Fail is one of the seminal texts on the topic.
• Market Determined Interest rates. Developing countries often use repressed interest rates to channel funds from households to firms to give business cheap access to credit. The problem with this is that it makes credit scarce because people have less incentive to save. It has a place in the early stages of development as has been used successfully by giant domestic markets like China and countries that were industrialising before globalisation, but it’s generally considered a bad idea nowadays and just a kind of corporate welfare.
• Fiscal Discipline. This is where things get a little interesting. The structural adjustment loans were given out to countries with massive debt problems. Austerity was part of the package. It is the austerity that is controversial rather than fiscal discipline per se. I don’t think many people would dispute that saving when times are good, spending when times are bad (note that Keynes and Hayek were mates and this isn’t a contradictory approach to fiscal policy) and generally trying to stay within your means is a bad idea.
• Currency Devaluation. This is the big one and again, isn’t really part of the Washington Consensus but is instead part of the structural adjustment lending scheme. Indeed, currency devaluation constitutes a very strong intervention into the market, which is against the ethos of the consensus. Moreover, very few countries exercise strong controls over their currencies these days (most opt to float), so this isn’t even really relevant anymore. However, at the times of the structural adjustment loans, recipient countries often had very strong controls on their exchange rates and the IMF and WB believed them to be too high. It was hoped that devaluation would improve export competitiveness and lead to growth in tradable goods sectors. Unfortunately, devaluation also increased the price of exports and reduced real incomes, which lead to demands for higher wages, which lead to more devaluation, which lead to higher prices, which lead to demands for higher wages, and then a wage-price spiral and rampant inflation which basically fucked everything.

I’ve alluded to most of the reasons why the consensus makes sense to develop economists and to why it failed (the devaluation and austerity programs). There is one more thing that is critical to underline. It is that the reason for the failure of trade liberalisation in Africa and Latin America is not because free trade is bad per se. Rather, the IMF and WB, institutions of the US and EU, forced Africa to drop its trade barriers without acknowledging that US and EU markets would remain closed to African exports (principally of agricultural goods). Africa and Latin America thus became dumping grounds for expensive Western consumer durables and could not generate revenue through exports in turn. This prompted a balance of payments crisis, exacerbated by the currency devaluations, that crushed the associated economies.

There is no doubt that the structural adjustment loans were a failure if not a catastrophe. Theory, anecdote and cross-sectional studies drive that home. But that doesn’t mean that we should abandon all of the ideas in the Washington consensus. It especially does not mean that we should treat open trade and open capital flows as bad. On the other side of the planet in Asia where the IMF and World Bank have little role, trade barriers are virtually nill and foreign direct investment is enormous, development has been brisk and very inclusive. Trade and FDI and the other aspects of the Washington consensus are fundamental to the growth story of all of Asia, but especially ASEAN and Australia. The Asian Financial Crisis has strong consequences for some early theories of financial liberalisation, but that is a topic for another article.

We need to be very careful about the lessons we draw from complex interventions like the structural adjustment loans. There are a lot of bastards out there trying to rip people off. But there are also a lot of very good people trying to figure out what works and what doesn’t. Take the time to separate the two.