Economic Growth in the 1990s Page 1 of 2 Contact Us • Help/FAQ • Index • Search Home > Economic Growth in the 1990s Economic Growth in the 1990s: Learning from a Decade of Reform The World Bank's Poverty Reduction and Economic Management (PREM) Network has prepared a study on development lessons of the 1990s. The report reviews the growth impact of the main policy and institutional reforms introduced in the 1990s, presents a broad perspective on the events, country experiences, academic research and controversies of the decade, and reflects on how they alter our thinking about economic growth. Economic Growth in the 1990s: Learning from a Decade of Reform can be purchased from our online bookstore. The report complements a series of lectures by leading development practitioners such as Larry Summers, President of Harvard University and Former U.S. Secretary of the Treasury, and Fernando Henrique Cardoso, Former President and Former Minister of Finance of Brazil, discussed their experience as policy makers at the forefront of policy implementation in the 1990s. Table of Contents Foreword Gobind Nankani 1. Overview PART 1: FACTS OF THE 1990s 2. Grist and Mill for the Lessons of the 1990s Country Note: Economic Growth from the Very Long-Term Perspective of History 3. Something Special about the 1990s? Country Note: Lessons from Countries That Have Sustained Their Growth PART 2: DEVELOPMENT CONTROVERSIES OF THE 1990s 4. Macroeconomic stability: the More the Better? Country Note: Poverty and Inequality: What Have We Learned in the 1990s 5. Trade Liberalization: Why So Much Controversy? Country Note: The Middle East and North Africa: Performing below Potential 6. Privatization and deregulation: a push too far? Country Note: Eastern Europe's Transition: Building Institutions 7. Financial Liberalization: What Went Right, What Went Wrong? Country Note: Lessons and Controversies from Financial Crises in the 1990s 8. Policy Reforms and Growth Performance and Growth: What Have We Learned? Country Note: Why Blessings become Curses? 9. Improving Public Sector Governance: The Grand Challenge? Country Note: Africa's Growth Tragedy: an Institutional Perspective 10. Politics: Does Democracy Help? Bibliography http://www1.worldbank.org/prem/lessons1990s/ 11/27/2006 Overview from Economic Growth in the 1900s: Learning from a Decade of Reform, World Bank, April 2005 Chapter 1 Overview E CONOMIC GROWTH IS A RECENT policy and institutional reforms. Section 5 sketches event in the history of humanity. operational implications. Subsequent chapters set During most of 4 million years of out the facts about growth in more detail, and then evolution, people made limited economic progress examine the main areas in which economic and and their material well-being changed very little. In institutional reforms concentrated during the the last few centuries, however, goods and services 1990s—macroeconomic stabilization, trade, finan- started to be produced at increasingly lower cost in cial sector, privatization and deregulation, modern- hours of effort.The hours of work needed to pro- ization of the public sector, and political reforms. duce basic goods such as water or heat at the dawn The chapters aim to draw lessons from gaps of civilization were several hundred times those between expectations and outcomes. Most chapters needed today (DeLong 2000). Similar increases in are also followed by a Country Note that expands productivity have been achieved for an expanding on issues insufficiently dealt with in that chapter, or range of goods and services. Most of this progress that considers country-level perspectives. has taken place in the last two centuries, during which technological progress has been exception- FIGURE 11 ally rapid, and economic growth unprecedented Worldwide Growth in Real GDP per Capita, 1000–Present (figure 1.1). It is only in the last 50 years that mainstream 100% Century's growth in real world GDP economics has focused on the determinants of 90% Adam Smith’s “natural progress of opulence” and 80% on how growth could be accelerated. Many ques- 70% tions about growth still lack satisfactory answers.Yet 60% per capita few issues are more important for the world’s future 50% than the ability of developing countries to raise 40% both productivity and the rate at which they accu- 30% mulate capital. 20% This overview chapter first briefly reviews our 10% understanding of growth before turning, in section 0% 2, to the facts and controversies of growth and pol- –100% 11th 12th 13th 14th 15th 16th 17th 18th 19th 20th icy reforms in the 1990s. Section 3 draws the broad Century lessons coming out of the growth experience of the Source: DeLong 2000. 1990s, and section 4 offers lessons specific to key 1 2 E C O N O M I C G ROW T H I N T H E 1 9 9 0 s 1. Understanding Economic Up to then, thinking about growth had been dominated by the Solow model, the basic model Growth with which we still think about economic growth, Absent definitive theories, views on growth have in which growth is a function of the accumulation been shaped by facts and changed by experience. of capital, accumulation of labor, and productivity Until the 1970s, the growth strategies of developing growth.This model leaves out much of what needs countries focused on accelerating the rate of capital explaining. In particular, it views long-run growth accumulation and technological adoption. Import as entirely determined by exogenous factors, inde- substitution, state-owned enterprises, controls over pendent from structural characteristics of the econ- the financial sector, central planning, and a variety of omy such as openness, scale, and saving rate, and, price controls and state interventions in the econ- most important, from the policies influencing such omy were some of the policies that governments variables.Also, while left unexplained in the model, used to take the “commanding heights” of the econ- productivity growth drives the empirical story. omy and guide resource allocation to areas thought Solow himself estimated that technological change to be most conducive to long-term growth. Confi- explained more than half of per capita output dence in governments was born from their (partial) growth in the first half of the 1900s in the United success in addressing the Great Depression, in States. Calculations by the World Bank indicate that expanding production during World War II, and it explained one-third of the increase in per capita reconstructing Europe and Japan. Economists and income in East Asia up to the early 1990s (World policy makers saw that market forces disrupted Bank 1993). Other exercises reach similar conclu- growth and that governments were able to restore it, sions on the large role of productivity gains in and to expand capacity efficiently.The generation of growth experiences. economists that followed, however, familiar with At first the New Growth Theory seemed to hold experiences of developing countries in the 1970s and the promise of linking policies to growth perform- 1980s, saw the waste of enormous resources in ill- ance. It appeared at a time when evidence was accu- conceived government initiatives, the costs of poor mulating—from the growth experience of the 1970s macroeconomic management, and the ease with and 1980s—suggesting that the accumulation of cap- which well-intentioned public policies could be ital was not a panacea, and that misguided policies diverted to serve narrow political or economic inter- were costly for growth.The new evidence provided ests. Understandably, this later generation of econo- the conceptual foundation for aggregate cross-coun- mists and policy makers came to believe that the cost try regressions, which throughout the 1990s sought of government failures was considerably larger than to capture the effect of policies on long-term growth the cost of market failures, that government inter- (Barro 1991; Temple 1999) and provided the ventions interfered with development, and that con- strongest intellectual foundation for the view that taining the role of the public sector in the economy, better policies would deliver faster growth. reducing its use of resources, and limiting its discre- A number of empirical problems became evi- tion were essential for economic growth. dent, however, related to the crude manner in which policy variables enter the cross-country regressions; the fact that differences in the institu- New Growth Theory tions underlying policy design and policy imple- This shift in views was supported by a new strand of mentation are not captured; the lack of robustness academic research that started in the second half of to changes in time periods and specifications; the the 1980s and gathered impetus during the 1990s, crudeness of the assumption that the same model when there was a resurgence of academic and explaining growth in the Republic of Korea or empirical work on growth. Brazil could be used for Bolivia or Rwanda; and the I N T RO D U C T I O N 3 poor predictive power of policies as indicators of Nonetheless, in the process, greater clarity was performance. reached on the facts about growth, analysts paid If, as suggested by the growth regressions, poli- greater attention to the role of institutions,and stud- cies matter for growth, policy improvements should ies brought the issue of inequality—both within lead to higher growth. Both in the 1980s and 1990s, and between countries—increasingly to the fore. policies improved relative to other decades, but growth performance remained well below that of the 1960s and 1970s (Easterly 2001). More recently, Growth in Developing Countries: empirical research has argued that when a measure Divergence,Variability, and Unpredictability of “institutional quality” is included in cross-country Research during the 1990s was able to extend the regressions, the explanatory power of other vari- availability of data over long periods.This made it ables, including all measures of “policies,” becomes clear that growth was not a linear process, and that negligible (Acemoglu, Johnson, and Robinson it did not conform to the theoretical prediction 2001; Rodrik, Subramanian, and Trebbi 2002; East- that per capita income in developing countries erly and Levine 2003; and IMF 2003e).This suggests would eventually converge with that of industrial- that “good” institutions matter more for growth ized countries. In fact, there has been “divergence than “good” policies—that “institutions rule.” big time” in the evolution of per capita incomes In hindsight, the breakthroughs expected from (Pritchett 1997), both between industrialized and the New Growth Theory have not materialized. developing countries and among developing coun- FIGURE 12 Economic Growth in Perspective, 1960–2002 20% 15% 10% 5% 0% 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 Latin America and the Caribbean Sub-Saharan Africa South Asia Middle East and North Africa Europe and Central Asia East Asia and Pacific Source: WDI 2003. Note: Regions’ GDP per capita is shown as a percentage of the OECD GDP per capita (total regional GDP over total population). 4 E C O N O M I C G ROW T H I N T H E 1 9 9 0 s tries themselves.This is the case whether the period being considered is the last 40 years (figure 1.2) or FIGURE 1.4 the last 10 (figure 1.3). Fraction of World Inequality Accounted for As a result, worldwide inequality has changed by Differences across Countries from being the result almost exclusively of differences Fraction of total inequality due to 70.0% among people within countries to being the result pri- differences across countries 60.0% marily of differences across countries (figure 1.4). The consideration of growth over longer periods 50.0% also highlights the variability of growth in developing 40.0% countries. The experience of Latin America since 30.0% the 1980s, the collapse of growth in Africa in the last two decades, and the economic collapse of Eastern 20.0% Europe after several decades of sustained growth 10.0% stand in sharp contrast to the stability of growth 0.0% among industrialized countries, which have grown 1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000 at roughly a constant rate (except for the interrup- tion of World War II and recovery years) for more Years than 100 years. It also contrasts with the experience Theil coefficient Mean ln deviation of East Asian countries. What is remarkable about Source: Source: Bourguignon and Morrison 2002. East Asia is not that it experienced a crisis in 1997, but that it experienced so few crises over the pre- ceding decades. By and large, developing countries half that rate. Korea has only had only three years of have one year of negative per capita growth roughly negative per capita growth since 1961.1 once every three years. In East Asia, the average is The variability of growth helps to explain why growth in the developing world is so difficult to predict. Instances of economists (including, for example, 1977 Nobel Laureate James Meade on FIGURE 1.3 Mauritius) making highly inaccurate predictions Regional Perspectives on Growth in the 1990s have become part of the economic folklore. Many of the economic successes of today—Bangladesh, 200 Indonesia, Korea, or Mauritius—were considered Per capital GDP (1990=100) 180 “basket cases” in the 1960s, when Africa’s growth 160 prospects were seen as superior to those of over- 140 populated Asia—a view captured in Asian Drama (Myrdal 1972). In the later 1990s, just before the 120 second most dramatic economic crisis in its history, 100 Argentina was seen as a model for developing coun- 80 tries and believed to have found the path to sus- 60 tained growth. At a more technical level, World 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Bank growth projections, as well as growth projec- East Asia and Pacific South Asia tions by other forecasters, tend to be systematically Eastern Europe and Central Asia Sub-Saharan Africa Latin America and the Caribbean overoptimistic (a point that was highlighted in the Organisation for Middle East and North Africa Economic Co-operation World Bank’s World Development Report 1991). Source: WDI 2003. While a rare occurrence thus far, sustained growth has improved the lives of millions. Coun- I N T RO D U C T I O N 5 tries where sustained growth has taken place larly in capital-intensive industries, because old eco- (mostly in South and East Asia, including nomic interests resisted change and were unwilling Bangladesh, China, Indonesia, India, and Vietnam) to take on risks inherent in new industrial activities; account for a large proportion of world population. price controls did not have serious economic con- Out of 117 countries with populations of more sequences because the concentration of wealth pre- than half a million people, only 18 have been able cluded the redeployment of resources in response to sustain growth rates exceeding industrialized to changes in demand (Seers 1962). countries’ growth and hence narrow their per capita While there are some functions that institutions income gap with those countries.2 need to perform in any society, the form through which institutions can perform these functions can vary considerably (Virmani 2004). Most of the Institutions empirical work on the importance of institutions Defined as the rules and norms constraining human leaves open the question of how to improve institu- behavior (North 1990), institutions include the tional performance. Merely adopting some other informal rules and norms that govern personal and country’s laws and formal regulations is no guaran- social behavior and the formal rules and norms tee of achieving the same institutional performance. governing economic, social, and political life. Insti- Recently, accession to the World Trade Organiza- tutions enable societies to organize themselves and tion and integration into regional supra-national function in an orderly manner by solving problems entities such as the European Union and the New central to life in society, particularly agency prob- Economic Partnership for Africa have strengthened lems, containment of predation by individuals or incentives for institutional improvements. East Asian the state, and collective decision making. Societies’ countries have long realized the importance of performance depends on how effectively their insti- institutional change and innovation, and the 1997 tutions resolve these problems. crisis made this realization all the more acute, creat- The importance of institutions for economic ing renewed impetus to modernize institutions, prosperity is not a novelty learned from the 1990s. including political institutions. But for most devel- From different perspectives, Adam Smith, Karl oping countries, improving the quality of their Marx, and Max Weber highlighted the role of insti- institutions remains a challenge. tutions in the development of a market economy and formation of a capitalist society. Economists dealing with development in the 1950s and 1960s Fairness, Growth, and Institutions were aware that the development challenges faced Another important strain of ideas in the 1990s came by a plantation economy differed from those faced from the resurgence of interest in inequality as an by a society where economic and political power apparent influence on growth and institutional per- were not concentrated (Rostow 1952, 1960; Adel- formance. A recent body of literature suggests sev- man and Morris 1965). Latin American economists eral channels through which inequality affects of the Structuralist school saw in the legacy of colo- economic growth. Fairer societies offer their citi- nialism, embedded in institutions serving the inter- zens more public goods, more social support, and ests of a small, landed elite, the source for economic more social capital. Hence they are more capable of performance inferior to that of the United States or sharing the costs and benefits of improving eco- Canada (Furtado 1963). This imbalance formed a nomic policies, and in turn facilitating consensus part of the justification for an activist state: inflation building and decision making (Deaton 2003a). Fair- helped to mobilize resources from the wealthy elite ness also facilitates agreement on the provision of who resisted more efficient forms of taxation; states public goods that have strong beneficial side effects sponsored investments in manufacturing, particu- on society, such as health services, water supply, or 6 E C O N O M I C G ROW T H I N T H E 1 9 9 0 s waste disposal. Other channels through which States in the early 1900s, when the government inequality affects growth are market structures and decided to regulate matters hitherto left to private microeconomic incentives. A better distribution of parties and the courts; the reason for the shift was a wealth reduces credit constraints, and broader avail- perception that judges and the courts, having been ability of credit is found to have a significant and corrupted by powerful economic interests, were positive effect on growth rates. If individuals are unable to render fair and equitable judgments. World limited in their borrowing capacity, reallocating Development Report 2001 provides other examples of capital toward the poorest will increase aggregate how economic incentives affect the emergence of productivity. institutions that sustain the functioning of markets, Even if one concludes that greater equality and the different coordination or risk-reducing influences growth positively, there is still consider- problems that they are meant to resolve. able ignorance about the means through which greater equality can be achieved. Governments have long sought, with varied degrees of success, to redis- 2. Facts and Controversies of the tribute income through land redistribution, 1990s employment programs, subsidies, and promotion of broad access to credit, infrastructure, health, and At the beginning of the 1990s, most economists education.The large, underresearched area for fur- working on development and many policy makers ther study includes questions related to the impact shared the conviction that more efficient use of of public spending on equity, both in a static sense resources would lead to growth.This was believed (incidence of public spending) and a dynamic sense to require, first, macroeconomic prudence, domes- (changes in individuals’ earnings potential). tic liberalization, and outward orientation, which in Recent literature has emphasized the important turn required freeing market incentives and open- links between the distribution of assets in a society ing the economy. Hence fiscal deficit reduction, and the institutions that emerge. Knowledge is still realignment of exchange rates to eliminate black rudimentary about how institutions emerge and are market premia, lifting controls on prices, deregula- established in a society, but economic research in the tion of interest rates and liberalization of the finan- 1990s has provided some insights. First, economic cial sector, and reduction of tariffs and other incentives influence what type of institutions restrictions on imports all became central to the emerge and when. The enforcement of property policy reform programs implemented in the 1990s. rights to land, for example, will depend on the ben- Second, conventional wisdom held that to efits of enforcement relative to its costs, which for achieve greater efficiency required a reduction in each owner depends on the extent to which other the role of the state. There was evidence that the owners enforce their property rights. In an extrac- state discretion that was inherent in growth strate- tive economy, for example if landowners in general gies based on infant industry, import substitution do not enforce their property rights, it is uneco- policies, and the growth of public enterprises had nomical for one landowner to enforce his: workers been misused more often than anticipated, had will find it attractive to exploit land and appropriate often been captured by narrow interest groups, and the rents for themselves. Only when this coordina- served as the source of endemic corruption. tion problem is resolved will economic incentives Addressing this problem required reducing state be sufficient for enforcement of property rights discretion, downsizing governments, and encourag- (Hoff and Stiglitz 2001). Second, concentrated eco- ing a much greater role for the private sector. Hence nomic and political interests influence institutions. privatization, deregulation, elimination of quantita- This can be seen from experiences with land distri- tive restrictions and of licensing requirements, and bution in Latin America, and also from the United dismantling agricultural marketing boards and I N T RO D U C T I O N 7 other forms of state monopoly all became central reducing hyperinflation and reversing several to reform programs. Seeing the need to strengthen decades of state-led import-substituting industrial- the organizational effectiveness of the state, and the ization. In Argentina, President Menem set the efficiency with which the state used public country on a course of eliminating hyperinflation resources, reformers rationalized government func- through a currency board as well as ambitious mar- tions and undertook civil service, legal, and budget ket reforms, which saw the privatization of state- reforms. Democratic processes were expected to owned businesses and liberalization and opening of provide checks and balances and further incentives the economy. In Bolivia, reforms by Paz Estensoro to this process. that had brought hyperinflation to a halt in the Third, it was believed, reforms had to be rapid. mid-1980s were continued in the 1990s, regardless Earlier, some of the first authors to argue in favor of of the parties in government. In Africa, the devalu- abandoning the dirigiste framework of early devel- ation of the African Financial Community (CFA) opment economics (notably Little, Scitovsky, and franc increased competitiveness and many other Scott 1970; McKinnon 1973) had argued explicitly reforms were implemented throughout the region. in favor of a gradualist reform strategy (in respect to In Tanzania, President Mkapa started an ambitious trade and the financial sector, respectively).3 But in program of reforms. In South Africa, the transition the course of the 1980s the economics profession to a multiracial democracy was followed by steps began to be influenced by the enthusiasm of lead- toward liberalizing the economy. ing politicians for “the magic of the market.”Argu- Leaders such as Rawlings of Ghana and Musev- ments in favor of “big bang” and “shock treatment” eni of Uganda strengthened fiscal fundamentals, became prominent. By the time that the transition achieved macroeconomic stability, liberalized the to a market economy got under way in the former economy, and reduced the role of the state. Privati- socialist economies, “a belief in gradualism had zation, retrenchment of the public sector, and liber- almost become tantamount to a confession of a lack alization of trade were the focus of economic policy of reforming virility” (Williamson and Zagha changes in countries as diverse as the Central 2002). African Republic, Ghana, and Tanzania. Reforms in the Middle East and North Africa were less ambi- tious but were nonetheless significant in the Arab A Decade of Significant Change Republic of Egypt, Jordan, Morocco, and Tunisia. The 1990s provided ample opportunity for these On the political front, democracy spread in former views to be implemented.The Russian Federation, communist countries and Africa, and was consoli- Eastern Europe, and Central Asia embraced capital- dated in Latin America. These and other changes ism and a new generation of leaders made it a pri- gave rise to expectations that the 1990s would ority to rebuild their economies on the basis of accelerate growth and social progress in the devel- capitalist principles, markets, and privatized firms. oping world. Regarding the speed of reform, while there were divergences, the balance of opinions supported Rapid Growth, Take-offs, and Social Progress rapid rather than gradual reform. China, the largest India and China, together accounting for 40 per- developing economy, continued the reforms it had cent of the developing world’s population, grew fast begun in 1978 with further liberalization of the in the 1990s for a second decade in a row, as did domestic economy, and increased openness. After many other countries in South and East Asia, its crisis in 1991, India, the second-largest develop- including Bangladesh, Sri Lanka, and Vietnam. ing economy, speeded up liberalization started in Chile continued to grow in Latin America,Tunisia the 1980s. President Collor of Brazil announced a in North Africa, and Botswana and Mauritius in radical program of economic reform aimed at Africa. New high performers appeared and annual 8 E C O N O M I C G ROW T H I N T H E 1 9 9 0 s gross domestic product (GDP) growth for the positive developments occurred in the later 1990s, decade was rapid in an array of countries: Mozam- such as in Mozambique,Tanzania, and Uganda, and bique (7.8); Uganda (6.8), Dominican Republic still persist at the time of writing, it is too early to (6.0), Tunisia (5.0), and Poland (4.5). Countries conclude that Africa has turned the corner. affected by the crisis in East Asia made an unex- pectedly rapid recovery. Financial Crises Notwithstanding unevenness across regions, the Financial crises in the 1990s were less predictable incidence of poverty continued to decline through- than in the 1970s and 1980s. Macroeconomists, out the 1990s—more rapidly in East Asia than in bank restructuring experts, and emerging-market South Asia and more rapidly in South Asia than in private traders rolled from crisis to crisis: from Mex- Latin America. In Africa, however, the incidence of ico during 1994–95, to Korea, Malaysia, Thailand, poverty increased slightly. Growth was the main Indonesia during 1997–98, Russia in 1998, Brazil force behind virtually all cases of significant reduc- in 1998, and Turkey in 2001 to the latest and per- tions of poverty, including in China and India. But haps most worrisome of all, in Argentina during particularly in Latin America, there were instances 2001–02. The evolution of spreads in the months such as Brazil and Bolivia where social indicators preceding the financial crises suggests that few were improved without significant growth. anticipated. Alongside these positive developments, how- ever, there were several negative surprises. Delay in Recovering Growth, Particularly in Latin America “Transition Recession” in the Former Soviet It was hoped that the “lost decade” of the 1980s Union and Eastern Europe would be reclaimed in the 1990s. Macroeconomic The transition from a communist, centrally planned stabilization, fiscal austerity, trade liberalization, and economy to a capitalist one was expected to be dif- privatization were expected to lead to rapid growth. ficult. But the depth of the output collapse was not Although growth was the fastest in two decades widely predicted. The length of the transition—in until 1998, its collapse thereafter following the which many countries in 2003, more than a decade reversal in capital flows created the general percep- later, remain far below their previous levels of out- tion that the growth payoffs have been smaller than put—was not widely forecast. Nor was the variabil- expected. ity among countries in the depth and duration of the output collapse.Though recoveries have started Argentina: The Collapse of the Hard Peg to emerge—in the Czech Republic, Hungary, and Argentina was the most successful example of a Poland, for example—it will take years, and in some trend in the 1990s to create macroeconomic stabil- cases, decades, for most former Soviet countries to ity by legal and institutional changes intended to regain their per capita income levels prevailing at reduce the scope and latitude of government’s dis- the beginning of the transition. cretion. Exchange-rate arrangements that set a fixed rate for peso convertibility were not only incorpo- Continued Stagnation in Sub-Saharan Africa rated into law but also made especially difficult to The failure of growth in Africa—either of powerful alter, and changes were made in the operation of and rapid growth in a single large country or in a the central bank to make these limitations a reality. substantial number of smaller ones—was a surprise. As part of a package of reforms, this convertibility Despite good policy reforms, debt relief, continued plan eliminated Argentina’s hyperinflation and, for a high levels of official assistance, promising develop- period, it restored economic growth. ments in governance, and a relatively supportive Once Argentina achieved stability with growth, external climate, no take-off has ensued.While some there was considerable discussion—particularly I N T RO D U C T I O N 9 after the devaluation of Brazil’s real in January It has been suggested that lower OECD growth 1999—as to whether the country should abandon might have depressed developing countries’ growth its rigid exchange rate system. Views diverged in the 1990s (Easterly 2002). In reality, the 1990s among economists. Looking back, the former Gov- was favorable for developing countries, even if not ernor of Argentina’s Central Bank described the every country found ways to benefit. Exports from abandonment as a marriage to be broken when it developing countries as a group grew much faster was going well (Mario Blejer,World Bank 2005b). than in previous decades. Real interest rates were For fear that markets could overreact, Argentina’s lower. Debt obligations claimed fewer resources, authorities maintained the system. When the plan and foreign direct investment and financial flows to collapsed, the result was politically and economi- developing countries were much larger. If com- cally costly by design. Thus the damage was not a modity prices affected developing countries surprise. But the demise of the convertibility plan adversely, the damage was not dramatic and should itself was a surprise, for two reasons. First, its initial have been offset by the increasing share of manu- successes had suggested longevity was possible; it facturing exports—except in a small group of least had reduced rapid inflation and initiated a boom in developed and Sub-Saharan African countries that the early 1990s, and it had weathered the “Tequila” remained highly dependent on agricultural exports. after-shocks of the Mexican crisis reasonably well. All in all, while external factors played a role, Second, while the end of convertibility was costly explanations of performance must be sought pri- by design, its actual cost exceeded the most pes- marily in developing countries’ domestic policies. simistic forecast. Good performance has been associated with domestic and external liberalization; Chile, India, China, and other countries in East Asia are all more Interpreting the Results open than in previous decades and have moved From a growth perspective, the net result of the toward greater reliance on market forces. But many contrasting experiences of the 1990s is that devel- aspects of these countries’ policies are still far from oping countries as a group grew faster than in the compliant with conventional wisdom. For example, 1980s. In East and South Asia this reduced the India has registered fiscal deficits several times higher income gap with industrialized countries, but in than Brazil’s or Argentina’s, with lower inflation and other regions, the gap increased. In Latin America, lower interest rates.While this fiscal trend is clearly there were clear gains up to 1998, reversed in the unsustainable in the long run, and measures have late 1990s and early 2000s (figures 1.2 and 1.3). been taken to correct it, it is clear that there is more Analyzing policy reforms of the 1990s, several to macroeconomic stability than a superficial read- studies (Loayza, Fajnzylber, and Calderon 2002; Lora ing of the size of the fiscal deficit. China has built 2001a; Easterly 2001) find that countries that extremely large contingent liabilities related to improved their policies—strengthening macroeco- unfunded pensions and nonperforming loans in the nomic management, opening up their economies, banking system.While, again, this is not a sustainable liberalizing their financial sectors—grew faster in the situation, it suggests that economies do not operate 1990s. However, they also find a large unexplained in mechanical ways, and that dynamism in one sec- negative effect associated with both the 1990s and tor can offset the cost of inefficiency in others. Sim- the preceding decade.Together with analysis of indi- ilarly, India’s and China’s industries, though vidual country experiences and overoptimistic fore- increasingly competitive in export markets, remain casts by international financial organizations and protected and state enterprises still play a large private entities, these studies give an empirical base (though declining) role in these economies. to perceptions that the economic policy reforms of The mismatch between predictions and results, the 1990s yielded results below expectations. and the successes of China, India, and Vietnam 10 E C O N O M I C G ROW T H I N T H E 1 9 9 0 s where there were substantial deviations from the intermediaries channeled to state enterprises and full package of reforms, suggest several possible related borrowers, contributing to the massive crises. explanations. First, sufficient time may not have yet In some cases, lack of competitive political forces elapsed for results to emerge in all countries. Over and such institutions as a free press allowed those time, market-oriented reforms may ultimately yield who were politically well connected to take advan- the results expected. Growth rates in African and tage of privatizations and to take control of natural other developing countries have rebounded since resources while enabling corruption to flourish. 1997; Argentina is experiencing its second year of These explanations are not mutually exclusive; rapid growth after the collapse of 2001–02; and one or more may apply to specific country circum- growth rates in Eastern Europe have increased. Sec- stances.The experience also holds some deeper les- ond, perhaps the reforms implemented in the 1990s sons. For example, while at one level Argentina’s were not sufficiently ambitious. Insufficient fiscal experience teaches that fixed exchange regimes adjustment in Latin America, very partial privatiza- require a very demanding set of conditions,a deeper tion in Africa, and insufficient openness to interna- lesson is that rigid rules are no substitute for credi- tional trade in the Middle East and Northern Africa bility, and that government’s discretion needs to be may explain performance below expectations in checked, not replaced with rules. Another deeper these regions. A third possible explanation is that lesson is that the reforms of the 1990s did not focus there were incoherencies in the implementation of on the binding constraints. For example, they policies.Argentina introduced a rigid exchange rate reduced fiscal deficits when perhaps the binding without the fiscal and financial conditions needed constraints were lack of public capital and aggregate to sustain it. Fiscal adjustments in some African demand. Or they reduced tariffs on imports when countries were achieved at the cost of reducing pro- perhaps the binding constraint was the workings of ductive public spending. Open capital accounts the financial sector. Or they focused on correcting encouraged pro-cyclical flows. Correction of these government failures, when the binding constraints incoherencies may enable growth to resume. were market failures. Perhaps most important, while reforms in the 1990s focused on increasing the role of markets and decreasing the role of the state, they tended to neg- 3. Lessons from the 1990s lect the role of institutions. Francisco Gil Diaz, Mexico’s Minister of Finance (as quoted in Krueger 2004), recently suggested that Promote Growth, Not Just Efficiency Reforms need to go beyond the generation of effi- The policies that have been undertaken are ciency gains to promote growth. The policy focus not even a pale imitation of what market of reforms in the 1990s enabled better use of exist- economics ought to be, if we understand ing capacity but did not provide sufficient incen- market economics as the necessary institu- tives for expanding that capacity. While this tional framework for a sound economy to emphasis on efficiency was warranted at a time of operate and flourish. What has been imple- extremely large distortions and waste, it also mented throughout our continent is a explains the frequent instances of stabilization with- grotesque caricature of market economics. out growth or liberalization without growth. The experience highlights the importance of the invest- State enterprises were privatized without much ment climate, and of providing predictable condi- attention to the operation of the markets in which tions for investors and other economic agents. they would function. Financial liberalization swelled It also highlights that growth entails more than the resources, foreign and domestic, that ineffective the efficient use of resources. Growth entails struc- I N T RO D U C T I O N 11 tural transformation, diversification of production, purposes resources and abilities that are hid- change, risk taking by producers, correction of both den, scattered, or badly utilized. government and market failures,and changes in poli- cies and institutions.It is also a process of social trans- In retrospect, it is clear that in the 1990s we often formation: people will change activities and live in mistook efficiency gains for growth.The “one-size different places. Social relations will change, and the fits all” policy reform approach to economic growth informal networks of rural life will be lost as other and the belief in “best practices” exaggerated the more formal networks and organizations are estab- gains from improved resource allocation and their lished. Entrepreneurs will invest in new machinery dynamic repercussions, and proved to be both theo- to produce new products and adopt new organiza- retically incomplete and contradicted by the evi- tional forms. Farmers will adopt new farming meth- dence. Expectations that gains in growth would be ods and change their product mix.The economy will won entirely through policy improvements were produce and demand different goods and services. unrealistic. Means were often mistaken for goals— These changes take place over time, alongside that is, improvements in policies were mistaken for changes in institutions that render them possible.Any growth strategies, as if improvements in policies growth strategy needs to include actions, both on were an end in themselves. Going forward, the pur- the policy and the institutional front,that address and suit of policy reforms for reform’s sake should be support this process of change. replaced by a more comprehensive understanding of Better policies can bring efficiency gains, and the forces underlying growth. Removing obstacles may increase incentives for investment, but without that make growth impossible may not be enough: amounting to a growth strategy.They will not nec- growth-oriented action, for example on technolog- essarily induce the behavior by private investors ical catch-up, or encouragement of risk taking for and the public sector that is needed to put an econ- faster accumulation, may be needed. omy on a sustained growth path. For this, faster accumulation of physical and human capital by Common Principles and Diverse Ways to both the private and the public sector are essential, as are gains in productivity. Implement Them This may explain why the growth impact of the Another mistake often made in the 1990s has been reforms of the 1990s was smaller than expected. the translation of general policy principles into a The incentives needed to expand productive capac- unique set of actions. The principles of the 1991 ity (“expanding the frontier” in economists’ parl- World Development Report, “macroeconomic stabil- ance) differ from those that are needed to use ity; domestic liberalization, and openness,” have existing capacity better (“movements toward the been interpreted narrowly to mean “minimize fiscal frontier”). What matters for growth is less the deficits, minimize inflation, minimize tariffs, maxi- degree to which policies approximate the ideal than mize privatization, maximize liberalization of “the extent to which a given development strategy finance,” with the assumption that the more of these is able to mobilize the creative forces of society and changes the better, at all times and in all places— achieve ever-higher levels of productivity” (Alejan- overlooking the fact that these expedients are just dro Foxley, in World Bank 2005b). And, in Albert some of the ways in which these principles can be Hirschman’s words (1958): implemented. There are many ways of achieving macroeco- Development depends not so much on find- nomic stability, openness, and domestic liberaliza- ing optimal combinations for given tion. As seen above, for example, the goal of resources and factors of production as on achieving macroeconomic stability does not imply a calling forth and enlisting for development need to minimize fiscal deficits at all times. A lower 12 E C O N O M I C G ROW T H I N T H E 1 9 9 0 s fiscal deficit achieved today through off-budget con- successful growth experiences in eight East Asian tingent liabilities, or through cutting back public economies, reported in the World Bank’s East Asian investments and thus reducing long-run growth and Miracle (World Bank 1993), resulted from diverse the future tax base, may mean a higher fiscal deficit policy and institutional paths, but common func- in the future. A lower fiscal deficit does not even tions were fulfilled along these paths.4 This perspec- guarantee greater macro-stability if it is based on tive has several implications. external borrowing in which interest rates are First, different policies can yield the same result, reduced at the cost of greater vulnerability to and the same policy can yield different results, exchange rate fluctuations, or if it is based on build- depending on country institutional contexts and ing off-budget liabilities through the banking sys- underlying growth strategies. This nonformulaic tem, which eventually translate into an increase in result holds not only for the eight East Asian public debt—as Latin American countries and economies featured in the 1993 study, but also for a Turkey found to their cost in the 1980s and 1990s. larger set of countries 10 years later. Countries with Similarly, trade integration can be achieved through remarkably different policy and institutional frame- various means that offset the effect of tariffs and works—Bangladesh, Botswana, Chile, China, reduce the implicit tax on exports. Duty rebate Egypt, India, Lao PDR, Mauritius, Sri Lanka, schemes, subsidized credit to exporters, and other Tunisia, and Vietnam—have all sustained growth in forms of export promotion, export processing per capita income at rates above the U.S. long-term zones, infrastructure, and transport corridors have all growth rate of close to 2 percent a year. helped China, India, Korea, and Mauritius to inte- Second,common to all successes is that four func- grate into the world economy while keeping their tions have been fulfilled: rapid accumulation of capi- tariffs relatively high in the initial phases of integra- tal, efficient resource allocation, technological tion and reducing them gradually over time.Thai- progress, and sharing of the benefits of growth. Rates land’s and Indonesia’s foreign domestic investment of progress in these four functions have not always regimes had few restrictions, whereas those of Korea been uniform, but successful countries have achieved and India had many until very recently—but both a balance among them over time, and disruptions Korea and India found alternative instruments to have ensued when the balance was not achieved. access and adopt modern technologies. Financial While there can be substitution temporarily, the bal- intermediation can be increased by relaxing entry ance will need to be reestablished at some point. restrictions in the banking system, or by improving For example, Korea’s policies in the 1960s and the workings of the legal system, particularly those 1970s sought to encourage risk taking by the pri- parts that deal with the repossession of collateral. vate sector. Import protection and priority lending To sum up,“getting the policies right” mistakes contributed to higher levels of capital accumula- means for ends. Clearly not everything can be right tion, at the cost of efficient allocation, which at once, and not everything needs to be “right” for became a more important priority in the 1980s. growth to take place—as witnessed in examples The Soviet Union, well into the 1960s, grew rap- from Bangladesh, China, India, Indonesia, and many idly on the basis of sacrificing consumption, accu- other countries. mulating capital, and maintaining a relatively equitable income distribution. But its considerable progress in science and technology was not effec- Common Functions and Diverse Ways to tively deployed in production and, more important, Achieve Them resource allocation was enormously wasteful. Even- To sustain growth requires key functions to be ful- tually, the costs of this inefficiency and the political filled, but there is no unique combination of poli- reforms of the late 1980s combined to bring growth cies and institutions for fulfilling them. The to collapse. In India, a “big push” in capital forma- I N T RO D U C T I O N 13 tion in the decades following independence was Different policies can have the same effect, and complemented in the 1980s—when evidence of the same policy can have different effects, depending misallocation and low productivity growth began on the context. In large economies, with access to to emerge—by policies that gradually freed market foreign technology and equipment, competition and forces and increased efficiency in resource alloca- economies of scale lessen the efficiency cost of trade tion (Virmani 2004), thus ensuring not only the restrictions and markedly widen the scope for suc- sustainability of growth but also its acceleration. cessful inward-oriented industrialization. Brazil, Factoring these four functions into analyses of China, and India were able to develop manufactur- growth makes it easier to understand why both ing, many segments of which became internationally policies and institutions play a role. For example, competitive, whereas in small countries such as capital accumulation by the public sector requires Jamaica and Uruguay, or Sri Lanka in the 1960s and sound tax policies and administration, sustainable 1970s, the market was too small; the benefits of macro policies, and a bureaucracy that is capable of inward-looking industrialization were negligible and formulating and managing public expenditure did not justify its costs. Sri Lanka became successful programs effectively and of choosing programs only after it began to liberalize imports in late 1977 with high returns. Accumulation by the private and follow export-oriented policies.Thus, the same sector requires at least reasonably secure private inward-industrialization policy produced different property rights, stable expectations about the outcomes because country characteristics differed. future, a stable macroeconomy, and access to Conversely, a given policy can yield different finance. One country might strengthen private results because of institutional variation. In Japan investment by, say, improving expectations, whereas during the Meiji industrialization and, more another country could achieve the same result by, recently, in Korea, public institutions were able to say, reforming the financial sector.5 Similarly, effi- resist pressures from narrow interest groups. Public ciency in allocation requires not only reasonably enterprises were run efficiently, and state ownership sound policies—such as competitive exchange built capacity in sectors that the private sector had rates and an open trade regime—but also institu- not entered because of perceived high risks. The tions that can enforce contracts and enable markets same policy in Bolivia, however, where public to function (World Bank, World Development Report enterprises were run for the benefit of narrow 2001). Technological catch-up requires not only interest groups, did not play a strategic role in the investment and trade policies that enable a country industrialization process, and most of the enter- to attract foreign direct investment (FDI) and prises were liquidated when Bolivia had to stabilize import equipment, but also institutions that, its economy in the 1980s. In the case of India, it has depending on the country’s development stage, been shown that in the presence of poor institu- promote adaptive research or a patent regime. tions, liberalization can lead to less growth than Indeed, in some instances, it is institutions and expected (Virmani 2004). political realities that define the set of feasible poli- Like that of policies, the effect of institutions cies, as testified by Russia’s former Minister of depends on the context. Security of ownership Finance Yegor Gaidar (World Bank 2005b): rights has been achieved in different ways and to different extents in different country contexts. In If I were the tsar of Russia, I would have Soeharto’s Indonesia, securing returns depended on done everything differently… But if I were connections with the ruling elite. In contemporary deputy prime minister and finance minister, China, the definition and enforcement of property in a government without a parliamentary rights depend on party and local government sup- majority and under many pressures, I would port—and only recently have initiatives been taken have done more or less what we did. in this direction. And in India, success depends on 14 E C O N O M I C G ROW T H I N T H E 1 9 9 0 s the functioning of a judiciary modeled after west- ways in which it can be exerted effectively. What ern legal systems. was learned in the 1990s is not only that sound Sharing the benefits of growth has been impor- policies do not necessarily engender the institutions tant in all sustained growth experiences, and partic- of a modern economy—that institutions are not ularly in countries with authoritarian forms of entirely endogenous—but also that institutions can government, where it has helped to legitimize prevent the adoption of growth-oriented policies regimes that often were neither fully representative or offset their impact. Experience showed how nor democratic.Various policies have been used to much institutions matter, and how hard it is to work promote the sharing of the benefits of growth.They around their absence or to improve their quality. include land reform and redistribution of other Above all, the experience showed that government assets; public expenditures on infrastructure (the 8- discretion cannot be bypassed. It is needed for a 7 program in China); social spending (Tunisia); poli- wide range of activities that are essential for sustain- cies to increase opportunities to economically ing growth, ranging from regulating utilities and underprivileged groups (affirmative actions for supervising banks to providing infrastructure and bumiputra in Malaysia); and poverty-targeted pro- social services. Improving institutions that support grams (food stamps in Sri Lanka or employment the implementation of policies, and strengthening programs in India and Bangladesh). checks on the use of discretion, are more promising To sum up, diversity in the form of successful guiding principles than seeking to eliminate gov- growth experiences should be no surprise. Each ernment discretion. successful country was successful in its own way. Much of the complexity encountered in the realm of economic institutions is also found in the Government Discretion Needs to Be institutions governing political life. The formal institutions of democracy, for example, do not nec- Managed and Checked, Not Replaced essarily ensure appropriate checks on discretion, by Rules nor are those checks always absent in authoritarian Because developing countries’ societies resolve regimes. Mechanisms and levels of accountability agency, predation, and collective decision-making can take very different forms, rarely amenable to problems less effectively than do those of industri- the simplicity of formal political institutions. Much alized countries, much of the reform effort in the of the growth success of East Asian countries can be 1990s sought to introduce policies that would limit attributed to these countries’ ability to allow discre- the discretion of national authorities in growth tion by different government agencies, alongside strategies and minimize demands on institutions. checks on this discretion that made them account- Privatization, financial liberalization, and removal of able.The forms of these checks varied: an authori- quantitative restrictions on imports are examples of tarian development-oriented political leader in policy reforms meant not only to improve incen- some cases (Soeharto’s Indonesia, Korea in the first tives for more efficient allocation but also to reduce decades of its take-off), the checks and balances the need for government discretion. Dollarization, inherent in complex one-party systems (China), or fiscal rules, or integration in larger economic unions the normal checks and balances of a democratic are examples of institutional reforms meant to regime (India, Sri Lanka). replace government discretion by rigid rules; they are consistent with the sense that, on balance, the Prudent Macroeconomic Management Is at costs of failures outweigh the benefits of discretion in the workings of an activist, developmental state. the Heart of Successful Growth Strategies However, government discretion cannot be dis- Avoidance of busts usually requires avoidance of pensed with altogether, so it is important to find booms.The costs of the crises of the 1990s in terms I N T RO D U C T I O N 15 of forgone growth, social distress, and public debt ance of payments increased; private-sector and gov- highlight once again the importance of prudent ernment debt exposures fed resistance to letting the macroeconomic management. They also stress the exchange rate adjust; governments sought to sustain importance of avoiding macroeconomic vulnera- the rate by drawing down reserves, but the policy bilities, and the risks associated with indiscriminate lacked credibility, or reserves were insufficient to opening of the capital account. Last but not least, sustain it; a large devaluation followed; and the they stress the importance of responding quickly to tightening effect of the devaluation was amplified downturns. One difference between successful and by the consequences of currency mismatches for less successful growth experiences is the frequency the balance sheets of banks or those of their bor- of downturns: virtually nonexistent for China, rowers and of firms. In Indonesia and Korea, for Korea, or Malaysia, but numerous for Argentina, example, where current account deficits were rela- Brazil, and Turkey. tively small, the trigger was the need for a large debt In addition to dealing with crises effectively, it is rollover at a time when investors were retreating also important to reduce financial fragilities and from emerging markets and when risk perceptions hence vulnerability to shocks.The financial crises of were on the rise.This was accentuated, in Indone- the 1990s differed from the many that preceded sia, by the uncertainty of the political transition. them because of their cost and their suddenness, and The booms and busts of the 1990s are reminis- they were much harder to predict.The risks of finan- cent of some of the crises of the 1980s.They teach cial integration had been underestimated and its several important lessons. First, as with most liquid- gains overestimated. In the 1990s in emerging mar- ity surges, busts inevitably follow booms: avoiding ket economies, the opening of the capital account to the bust requires avoiding the boom and strengthen- financial inflows triggered large surges that lowered ing the fundamentals.Countries such as Chile,India, the costs of sovereign and private borrowing and or Malaysia that managed inflows,including through helped reduce inflation. For those reasons, govern- the imposition of restrictions, were able to weather ments (with exceptions such as those of Chile, India, the crises much better than countries that took no Korea in the early and mid-1990s, and Malaysia) such precautions. Can a boom be distinguished from encouraged these inflows. Of the 10 economies that a favorable lasting trend, ex ante? In most cases the received the largest inflows, however, 7 suffered distinguishing factors are the volume of the surge, severe crises that took the form of large output the pressure it puts on the exchange rate, and its declines, higher incidence of poverty, and large impact on bank credit. Second, the crises of the exchange rate devaluations. The three exceptions 1990s highlight the extent to which banks can were China, India, and Hong Kong (China). amplify the consequences of a crisis, and the risks Each crisis was preceded by a large surge in associated with currency mismatches,including mis- inflows that either led to appreciation of the real matches on the borrowers’ balance sheets. Third, exchange rate and increased current account sovereign borrowing in foreign currencies is risky. deficits or, as in some East Asian countries, created While sovereign borrowing should, in theory, help a an external debt maturity profile excessively biased country to access external resources on better terms, toward the short term, and exposed unhedged in practice it has encouraged governments and pri- commercial banks to currency and maturity risks. vate firms to take excessive risks. In current account crises—many of which arose in the context of stabilization programs anchored on a Move Away from Formulaic Policy Making nominal exchange rate—the sequence of events followed a remarkably similar pattern: a surge in and Focus on the Binding Constraint(s) capital inflows put pressure on the exchange rate to A vital lesson for policy formulation and policy appreciate; the current account deficit of the bal- advice is the need to be cognizant of the shadow 16 E C O N O M I C G ROW T H I N T H E 1 9 9 0 s prices of constraints, and to address whatever is at any point in time, the constraint that most the binding constraint on growth, in the right man- severely limited growth, and the right sequence of ner and in the right sequence. This requires rec- policies needed in each situation.There may be sit- ognizing country specificities, and more uations in which a country needs to address many economic analysis and rigor than does a formu- constraints at once, as during the transition of East- laic approach to policy making. Policy makers ern European countries. These situations are rare, face the practical problem that no scientific however. In most cases, countries can deal with method permits ex ante identification of the most constraints sequentially, a few at a time. Success in important constraint(s) binding growth in specific addressing one or a set of constraints makes it eas- country circumstances, and hence the specific ier to deal with the others, and may help establish measures that are needed address it (them). Dur- virtuous circles. ing the 1980s and 1990s, China’s approach was to “cross the stream by groping for the stones.” Con- straints were identified and dealt with as the 4. Lessons from Policy and growth process unfolded, through experimenta- Institutional Reform tion and trial and error (chapters by Lim and Experiences in the 1990s Huang, in World Bank 2005a). Which policy should be introduced, and when, The economic policy reforms of the 1990s focused varies considerably from case to case depending on improving efficiency in the allocation of on initial conditions and institutional endow- resources through macroeconomic stabilization,lib- ments. For example, one can generally assume that eralization of trade and the financial sector, privati- where hyperinflation is raging, or public debt zation, and deregulation. Deregulation and demands high real interest rates—as it does in reduction in the role of government were expected Argentina, Brazil, Jamaica, and Turkey, for exam- to improve the governance of the public sector ple— macroeconomic stabilization is the first pri- through improvements in incentives for perform- ority. Where trade restrictions are extreme and ance, more transparency, and fewer opportunities hinder utilization of existing capacity, as in many for rent seeking. Institutional reforms focused on countries of the Middle East and North Africa, improving collective decision making and solving reducing them will be essential. Where there is agency problems through democratization, decen- uncertainty regarding the future course of eco- tralization, and public sector reforms aimed at nomic policies, as in Bolivia, Democratic Repub- enhancing the efficiency, transparency, and account- lic of Congo, and Nigeria, financial sector ability of government activities. From 60 countries liberalization will do little to channel resources to choosing their leaders through competitive elec- private investment. Where property rights are tions in 1989, the number rose to 100 by 2000. Del- poorly defined and enforced, and regulation pre- egation to subnational levels of government of vents the movement of domestic resources across political, administrative, and financial powers has sectors, as is still the case in some Central Asian taken place not only in federated states such as and some African countries, trade liberalization India, Brazil, and Russia but also in smaller states will be of little effect. and centralized states such as Bolivia and the Czech Experimentation and learning is hence an Republic. Deregulation and privatization have been important part of the growth process.The East Asia trends virtually everywhere, even though the inten- Miracle study highlighted that behind the miracle sity of the reforms has varied significantly from was the East Asian countries’ willingness to exper- region to region. iment, and ability to learn from, not to persist in, What have we learned from a decade of reforms their mistakes.This approach helped them identify, in these areas? I N T RO D U C T I O N 17 Macro-stability Needs to Be Achieved in to destabilize the economy, and they maintained the a Manner That Is Sustainable and competitiveness of the real exchange rate. These countries fared much better than those that opened Pro-Growth themselves to external liquidity surges. Notwith- The rise in real interest rates in the late 1970s and standing the theoretical arguments in favor of capi- early 1980s, combined with a variety of commod- tal account openness, the evidence on growth is ity price shocks, had rendered unsustainable the fis- inconclusive and volatility clearly increased. A cal stances, debt levels, and exchange rate regimes major lesson of the decade is that restrictions should of most countries in Latin America, East and South be placed not so much on outflows as on inflows. Asia,Africa, and the Middle East. Performance dif- Obviously, differentiating an unsustainable boom fered sharply between countries that rapidly from a positive sustainable trend can be difficult, but adjusted to these shocks (Korea and East Asian standard indicators of vulnerability such as indebt- countries in general) and those that did not (Brazil, edness, evolution of the real exchange rate, and cur- Nigeria, and many other countries in Latin Amer- rent account deficits have proven to be reliable, if ica and Africa). imprecise, tools. As a result, the Structuralist view that inflation Macroeconomic stabilization programs often and macro instability were inevitable companions of suffered from other design flaws, which created structural transformation and growth was replaced serious macroeconomic fragilities. While primary in the 1990s by the strong belief that macroeco- deficits did decline over the 1990s, public debt nomic stability was needed for growth.The 1990s increased in most countries, whether because of the indeed saw considerable progress in this area: fiscal bank recapitalization costs of financial crises (as in deficits declined in most countries, exchange rates Indonesia,Turkey), or because of the cost of contin- were adjusted to reflect market realities, black mar- gent liabilities being shifted to the public sector kets for foreign exchange disappeared, and inflation (pensions in Argentina), or because of high real declined virtually everywhere. However, while interest rates on the public debt (as in Brazil and macroeconomic policies as conventionally meas- Jamaica). Other design flaws help explain why the ured improved in a majority of countries, the search for macro-stability may in some cases have growth benefits failed to materialize. In addition, actually been inimical to growth. A preoccupation financial crises were numerous, with severe adverse with reducing inflation led some countries to adopt effects on economic growth and poverty. exchange rate regimes that ultimately proved desta- The openness of the capital account was a key bilizing—price stabilization was achieved at the cost source of fragility which, combined with unsound of appreciating exchange rates. Fiscal adjustment policies in the financial sector (such as currency was often based on highly distortionary taxes (for mismatches on banks’ or final borrowers’ balance example on external trade or on domestic financial sheets in the absence of hedging instruments) and transactions); or on cuts in spending on productive appreciation of the real exchange rate, helps to infrastructure or human capital that proved detri- explain many of the crises of the 1990s. Countries mental to sustained growth; or on borrowing such as India have avoided appreciation of the real abroad where interest rates were lower but currency exchange rate, and made the opening of the capital exposure increased risks. Hence a single-minded account a medium-term goal, to be realized con- pursuit of macro-stability sometimes came at the tingent on strengthened economic performance cost of public spending that might have both (including fiscal adjustment), export diversification, increased growth and made stability more durable. and achievement of a sound banking system. Chile There are two lessons to draw from this experi- and Malaysia, among others, did not hesitate to tax ence. First, even with macroeconomic stability, capital inflows when excessive liquidity threatened macroeconomic vulnerabilities induced by policy 18 E C O N O M I C G ROW T H I N T H E 1 9 9 0 s flaws can be serious, and these can have tremendous takes the form of a publicly announced inflation costs. However, indicators of sustainable macro-sta- target—has succeeded among emerging market bility are less self-evident than common indicators economies during the past decade (Brazil, Chile, of fiscal and external stance suggest.The inability of Colombia, Korea, Mexico, Peru, South Africa, and financial markets (as measured by country risk pre- Thailand). This institutional arrangement has the mia) to predict most of the financial crises of the important advantages of flexibility (since the central 1990s provides further evidence that unambiguous bank is not constrained in how it attains its inflation indicators of risk are difficult to find. target) and commitment (since the central bank’s Second, the institutions underlying macroeco- prestige is publicly put on the line). nomic outcomes and stability matter as much as sta- bility itself.There is ample evidence that budgetary Trade Openness, a Key Element of processes influence fiscal outcomes and that coun- Successful Growth Strategies, tercyclical fiscal policy rules strengthen macroeco- nomic stability. Centralized budget processes lead to Can Be Achieved in Many Ways better balanced fiscal outcomes over time, and During the 1980s, the performance of countries countercyclical fiscal policies shorten cycles and that responded to shocks by increasing their out- narrow their amplitude. Few governments find it ward orientation (East Asian countries) contrasted politically appealing to run fiscal surpluses during sharply with that of countries that did not (Latin good times, however. Transparent fiscal rules, with America, Africa, most countries of the Middle East stipulated penalties for noncompliance, may be and North Africa). Most policy makers concluded effective in some contexts. In others, the creation of that openness mattered for growth and, as a result, institutions such as oil stabilization funds may be during the 1990s, most developing countries signif- needed to save windfalls. One promising example is icantly reduced tariffs on imports and dismantled Chile’s Structural Surplus rule, which establishes other forms of trade restrictions. As in the case of fiscal policy targets adjusted for the variation in macroeconomic reforms, however, the results var- growth over the cycle. Other proposals, yet to be ied and, in general, fell short of expectations. adopted, have focused on creating an independent Whereas openness helped efficiency and growth in fiscal policy council, modeled along lines similar to many cases (East and South Asian countries, an independent central bank, that would set annual Botswana, Chile, Mauritius,Tunisia), it failed to do deficit limits.Another institutional dimension of fis- so in many others. Several lessons emerge. cal policy is transparency. Uncertainty about the First, openness to trade has been a central ele- state of the fiscal accounts probably played a large ment of successful growth strategies. Although the role in generating the volatility of the risk premi- paths taken toward greater integration with the ums that developing-country borrowers faced dur- world economy were far from uniform during the ing the 1990s. There is also evidence that more 1990s, the most successful developing countries transparent budgetary processes brought down reduced barriers to international trade and foreign deficits and debt. investment during the decade. For monetary policy, institutional arrangements Second, trade is an opportunity, not a guarantee. are equally important to ensure that low and stable Trade reforms in some countries yielded few gains rates of inflation are achieved and maintained, and in terms of export expansion or increased eco- that they last. However, there are no magic institu- nomic growth, while creating social and economic tional shortcuts to monetary credibility, which has adjustment costs. Liberalization of trade in to be earned through anti-inflationary perform- Argentina in the 1980s and 1990s, and in Chile in ance. The institution of an independent central the early 1980s, for example, was accompanied by bank—with a commitment to price stability that an appreciation of the real exchange rate that I N T RO D U C T I O N 19 reduced the competitiveness of domestic industries, tionship between trade reforms and poverty is to and incentives to exports—with adverse conse- date mostly indirect. Even where trade policy has quences for the balance of payments and the real reduced poverty, there are still distributive issues.An economy. In some countries of Eastern Europe in important policy lesson is that countries need to the 1990s, trade was liberalized while property help the affected workers move out of shrinking rights were not well defined, and the institutional (import-competing) sectors into expanding base for a market economy was not well developed. (exporting) sectors. These, and other institutional issues preventing the Fifth, the preservation and expansion of the free movement of resources, often meant that trade world trade system hinges on its ability to strike a reforms did not expand economic opportunities better balance between the interests of industrial- but restricted them instead (Bolaky and Freund ized and developing nations. Though more sup- 2004). Such experiences do not imply that less portive of development than at the beginning of trade reform would have been desirable, but that the 1990s, the world trade system is still biased trade reform must be done sensibly, as part of an against the poor. Notwithstanding a decade of sig- effective growth strategy. nificant expansion of international trade, global Third, countries that have successfully opened markets are most hostile to the products the world’s their economies have done so following a striking poor produce—agricultural products, textiles, and variety of policy approaches.They have opened up labor-intensive manufactures—and problems of different sectors at different speeds (for example escalating tariffs, tariff peaks, and quota arrange- Bangladesh and India). Some, such as China and ments systematically deny the poor market access Mauritius, have achieved partial liberalization and skew incentives against adding value in poor through the establishment of export processing countries. These problems are embedded in the zones, and some have combined unilateral trade remaining structure of protection in both industrial reforms with participation in regional trade agree- countries and developing countries (the latter ments (Mexico and countries in Central and East- owing to their own anti-export biases and also to ern Europe that have now joined the European higher barriers to trade in developing-country mar- Union). These differences, and differences in the kets), and they can be addressed through collective range of complementary policies adopted, make it actions.Those actions are best achieved through the difficult to pin down the statistical relationship Doha Round and the World Trade Organization between trade integration and growth. The aca- (WTO). Although there is a role for nonreciprocal demic debates on whether openness to trade causes preferences and for reciprocal regional approaches, higher growth are riddled with problems of meas- such preferential arrangements are economically urement, reverse causation (faster-growing coun- arbitrary; they come at a cost to excluded countries tries tend to open their markets more quickly), and and are not the best way to generate the right omitted variable bias (countries that successfully incentives for investment. lower tariffs and increase growth also adopt other complementary policies). Design Privatization and Deregulation Fourth, the distributive effects of trade liberal- with regard to Institutional Strengths and ization are diverse, and not always pro-poor. Trade reforms were expected to be pro-poor because in Weaknesses most societies the relatively wealthy and urban Privatization and deregulation have a potentially classes have been more successful at using protec- large efficiency impact and can benefit the popula- tion for their own benefit.The expectation was that tion at large, including the poor. But there is a need trade reform would increase the incomes of the to keep expectations realistic as to what they can unskilled.Yet evidence from the 1990s on the rela- achieve, to establish the institutions that are key to 20 E C O N O M I C G ROW T H I N T H E 1 9 9 0 s success, and to design privatization strategies taking cally ensure this separation.The well-publicized dif- into account institutional strengths and weaknesses. ficulties of doing business in countries such as Rus- Privatization and deregulation were key areas of sia show that a government can use a wide range of reform in the 1990s. Commercial public enter- laws to influence a firm’s decisions without owner- prises, development banks, and other forms of pub- ship. Separating the commercial from the political lic interventions in the economy, even when meant requires institutions that define and limit govern- to address market failures, had become discredited ment powers. Notwithstanding the claims of some because in many instances they had failed to work privatization advocates, institutions to support a well in practice. State activist policies using discre- well-functioning market economy will not spring tion, combined with weak accountability in public up quickly in response to demand. The lack of sector organizations and weak political accountabil- effective institutions permits predation through sev- ity of states to citizens, were producing costs that eral avenues, not just the government: in extractive were just too high.The end of communism, and the industries, for example, the mining or petroleum deregulation revolution in the United States and firm and the government are beholden to each the United Kingdom, added further impetus for the other, and either could act or collude at public wave of privatization that swept across the industri- expense.Vested interests could act through either alized and developing world in the 1990s. the public or private sector, and poor shareholder The results varied. In most countries, privatiza- oversight over a firm, as well as poor public over- tion brought unambiguous gains in terms of more sight over governments, permits misappropriation. efficient use of resources, more investment, and Turning to utilities, the second major area of enhanced welfare for consumers.At the same time, privatization during the 1990s, there are three main however, privatization itself failed to bring about all lessons. First, expectations of private investment in the gains for investment and growth that were infrastructure have been overly optimistic—because expected of it. It is also clear that too much was (1) underpricing continued to be a problem that expected from privatization, particularly in some governments did not fully address, (2) the risks of areas of infrastructure, but also in terms of the gov- infrastructure investment were not appreciated, and ernance improvements it would bring. In cases (3) governments could not credibly to commit to a where the overall package of reform failed to bring policy and regulatory regime. At the beginning of about the expected growth, even the efficiency the 1990s, the private sector was expected to enter gains of privatization were put in question—a prob- virtually all areas of infrastructure, including roads, lem that is particularly serious in Latin America and but experience has since shown that the risks Africa, where it has in some cases derailed the pri- involved in infrastructure investment are often too vatization process. large to be taken up by the private sector. In addition, the process of privatization has often Second, if privatization is overstated as a means been less than fully transparent and competitive, and of severing the link between economics and poli- this has left sequels that in some cases can be costly tics, regulation as a means of restoring the link is to repair—particularly where privatization has led underappreciated. The clearer the separation to concentration of economic power, as it has in between economics and politics, the better it is for many parts of Africa and Eastern Europe. each: commerce will be more efficient and politics Privatization is not just finding “better owners” less corrupt. But the more complex the regulatory than the government but about changing gover- issue, the more likely are mistakes, and the less likely nance to separate the commercial from the politi- that bad regulation (and capture of the regulators by cal. As is now widely accepted, government vested interests) will be detected. Even if detected, ownership of a commercial firm makes this separa- the poorer the institutions, the less likely it is that tion difficult. But privatization does not automati- bad regulation will be corrected. I N T RO D U C T I O N 21 Third, the reform experiences of network utili- almost universal pension coverage trimmed the ties clearly show that there is no universally appro- benefits of their defined benefit schemes, out of fis- priate reform model, and that privatization is not cal necessity. Many Latin American countries necessary or indispensable for every country. Every sought to phase out their defined benefit schemes restructuring and privatization program needs to and replace them with mandatory coverage by pri- explicitly consider the specific features of each sec- vate providers through defined contribution tor (its economic attributes and technology) as well schemes. Few of these schemes have lived up to as the country’s institutional, social, and political their billing: despite favorable demography their characteristics. Important lessons in this respect are coverage remains low because of the small size of as follows: the private formal labor market; their administrative costs have been high, partly because insurance costs • Regulatory reform should promote competi- are included and partly because of start-up costs, tion, not control; competition is the most effec- and they remain dependent on government tive regulator. finances because there are few securities besides • Getting the economics right is key. Understand- government paper to invest in.There was really no ing the source of benefits helps in structuring way to isolate these countries’ social security and the reform.A pricing policy that does not allow pension schemes from their governments without adequate revenue cannot improve the situation allowing them a greater range of investment in even if a utility is privatized or an independent external markets. regulator is established. For example, as of 2000, in almost all Commonwealth of Independent The Impact of Financial Liberalization on States (CIS) countries, household electricity Growth Depends on Underlying Institutions prices covered less than 50 percent and indus- trial prices were less than 70 percent of the long- and on Macroeconomic Management run marginal costs of supply. Over the 1980s and 1990s, as part of the general shift to a more market-oriented economy, the • Institutions differ, and hence regulatory agencies approach to finance shifted away from holding cannot be easily transplanted. Countries differ down interest rates, limiting competition, and rely- greatly in their economic structures and in their ing on governments to allocate credit and toward institutionsæthe whole chain that includes more market-based, internationally open systems. courts (where appeals are made), legislatures Financial liberalization reflected the reaction to the (where laws are passed), the press (which informs costs, corruption, and inefficiencies of financial the electorate), an engaged public (which repression; the demands of government and the demands more from governments), and acade- public for more financial resources and services; and mia (which trains regulators and encourages the pressures from greater trade, travel, and migra- studies of problems). These institutional differ- tion, and better telecommunications. ences across countries determine why what is Contrary to expectations, financial liberaliza- sound regulation in one country is ineffectual in tion did not add much to growth, and it appears to another.They are analogous to the differences in have augmented the number of crises.As expected, performance of state-owned firms: they are dis- deposits and capital inflows rose sharply as a result appointing in some countries (India, Mexico) of liberalization. But, other than in a few East Asian but not in others (Sweden or France). and South Asian countries, capital markets did not Pensions are an area in which the private sec- provide resources for new firms. Numbers of stock tor’s contribution has most clearly fallen short of market listings declined, even in the newly created expectations. Eastern European countries with markets in the transition countries that were some- 22 E C O N O M I C G ROW T H I N T H E 1 9 9 0 s times used for privatizations. Also, although rele- tribute to capital flight and devaluation), bank clo- vant time-series data on access are weak, and con- sure, and handling of explicit and implicit guaran- trary to expectations, it appears that access to tees to depositors; experience in the 1990s suggests financial services did not improve substantially after that it is difficult to avoid socializing the losses and liberalization. a fall in output. Further, open capital accounts and The explanation for these disappointing out- volatile international capital flows place a large pre- comes lies largely in weak institutions, concentrated mium on sound macroeconomic management. economic and political power, and macroeconomic Internationally, few attempts have been made to shocks. The implicit and explicit guarantees that reduce the volatility of capital inflows (reducing were extended to depositors and investors weak- volatility depends on limiting the upside, not just ened the market discipline that might have limited trying to stop outflows when a crisis develops). the activities of weak lenders. By the end of the Chile’s implicit taxes on short-term inflows appear 1990s, much of the deposit growth had been to have had some success in extending maturities, absorbed by central bank debt and government reducing inflows, and limiting volatility against deficits.The state banks, which remained important small shocks, albeit at the cost of reducing credit during the 1990s, and financial industrial conglom- availability to the private sector (Edwards 1999; erates used their increased deposits to expand lend- Forbes 2003). Part of India’s success in avoiding a ing to state enterprises, well-connected borrowers, 1997 crisis stemmed from its limits on banks’ (and and other parts of financial-industrial conglomer- firms’) offshore borrowing, even as it allowed ates. Regulation and supervision were weak, reflect- inflows into the stock market and eased direct for- ing not just technical problems but also political eign investment. Indonesia’s limits on state banks’ pressures for leniency. Eventually the poor quality external borrowing did reduce their growth, but of lending was exposed in crises, as were the weak- excessive inflows to private banks and corporations nesses of the bank privatizations in the context of were a major factor in the 1997 crisis. Except for the weak institutional environment and the exclu- Chile’s taxes on short-term flows and some sion, in many cases, of international banks. attempts to hold down interest rates, countries have The lack of improved credit access reflected not made few attempts to remove the incentives to only the preemptive borrowing by the public sector banks for increasing their offshore borrowings. All and central banks but also weak informational and attempts at limiting excessive inflows depend on legal frameworks. Lack of information on borrowers political will to restrict them during a boom. In hindered lenders and gave borrowers no incentive practice, countries often have eased restrictions on to maintain a good credit record. Weak legal and capital inflows to prolong a boom with negative judicial frameworks (designed to protect borrowers consequences when the flows necessarily slowed. and often responsive to economic and political Improvements are being made in regulation and elites) reduced the incentives to service debts; they supervision in an attempt to limit financial crises, made it difficult for new borrowers to gain access to but experience in the industrial countries, where finance by pledging collateral effectively and made it political and economic power is more diffuse than difficult for lenders to execute collateral. developing countries, suggests that this will not be The 1990s reinforced the old lesson that suc- easy. In the United States, for example, financial cessful financial liberalization depends on macro- economists have raised concerns about some U.S. economic management. No banking system, banks being too big to fail. Also in the United however sound in principle, can withstand a serious States, political forces and regulatory forbearance macroeconomic crisis. Dealing with a banking cri- are often cited as contributory factors in the savings sis is quite complex, involving highly political issues and loan crisis. In many developing countries a few of liquidity support to banks (which can easily con- large banks, often state-owned, dominate the sys- I N T RO D U C T I O N 23 tem. Bankers and major borrowers are often one tutions, defined broadly as the “rules of the game” and the same. Limits on connected lending are a that shape the behavior of organizations and indi- problem because the industrial-financial groups are viduals in a society (North 1990, 3).6 A crisis of also the main entrepreneurs in many countries, governance of varying intensity pervades much of even large ones. If problems of loan quality develop, the developing world, with the poor paying the the political strength of the economic and political heaviest price for it. elite will likely lead to regulatory forbearance in Public sector reforms in the 1990s sought to loan classification and provisioning standards.These change the structure of organs of the state, and kinds of problems suggest that attempts to improve incentives within them, in the hope of improving the regulatory and supervisory framework need to government efficiency and responsiveness. From include a substantial effort to improve market disci- mega-reforms such as decentralization to less pline, through better information on the banks and sweeping reforms in budget or personnel manage- credible limits on deposit guarantees. Increased ment, the aim was to find a balance between the entry of well-known foreign banks, which have a discretion of politicians and bureaucrats over policy reputation to protect, can also improve the func- making and policy implementation and their tioning of the system. accountability for decisions and actions.The fall of Thus, in finance, the 1990s may best be regarded authoritarian regimes and the consequent spread of as a transition period.The high expectations for lib- democratic processes constrained the previously eralization were met only in resource mobilization. wide discretion of many governments. Decentral- Resource allocation, which makes a key contribu- ization sought to further limit central government tion to development, did not generally improve. discretion while granting local governments more However, much of the debris of the old financial managerial autonomy. Legal, judicial, and legislative system was removed by the crises, albeit by govern- reforms were initiated to establish institutional ment recapitalization bonds that now represent checks on executive power. Public management much of the system’s assets. reforms sought to give public managers more flex- As the connecting link between savers and ibility in decision making while demanding greater investors, the contribution of finance to growth accountability from them for their decisions. Per- depends not only on macroeconomic stability and haps partly because of the immense difficulty of reasonable interest rates, but also on the quality of addressing problems in political institutions, many financial intermediaries and information and of the countries and donors in the 1990s focused largely legal and regulatory framework. Improving the on reforming legal and judicial systems—a channel contribution of finance to development will of political accountability that seemed more depend not only on market-based finance but also amenable to technocratic solutions, often using on sound institutions, appropriate incentives for models directly transplanted from industrialized lenders, further improvements in informational and countries. legal frameworks and, ultimately, on a more com- Most of the reforms had little effect on behav- petitive political system that is able to reduce the ior.The ills that they sought to treat—nonmerito- power of political-economic elites and their ability cratic civil services, weak financial controls, opaque to tap the financial system. or incoherent budget processes—are deeply rooted in local political and institutional arrangements that favor the status quo. Pragmatic, Incremental Approaches to Public The decade was not all discouraging, however. Sector Governance Are More Effective Homegrown initiatives gave hope for improving Economic performance depends partly on gover- government performance. In some instances, civil nance, which in turn is shaped by underlying insti- society engagement and participation and innova- 24 E C O N O M I C G ROW T H I N T H E 1 9 9 0 s tive applications of information technology led to Politics: Checks and Balances Are Central to improvements in transparency and accountability in Accountability and Results, but There Is No public decision making and consequently to some Single Way to Achieve Them increase in government responsiveness, efficiency, and effectiveness.The challenge is scaling up these Institutions resolve a number of problems in soci- initiatives, given political constraints and historical ety, of which two are particularly important: collec- inertia. tive decision-making processes, and principal-agent The designs of governance reform strategies in problems.7 Not all preferences can be represented the 1990s typically fell into two broad types: “big in collective decision making, and principal-agent bang” or ad hoc incrementalism. Big bang problems can be reduced but never resolved. approaches proved to be largely inconsistent with Both theory and evidence suggest that the for- capacity constraints and political realities. Their mal rules of democracy do not ensure efficient, main results were major changes in formal rules: accountable, and credible government, and con- new or amended constitutions, new legislation, versely that nonelected governments are not inca- ostensibly independent courts and audit institu- pable of responding to citizens or of acting tions, and so forth. Meanwhile, the informal rules accountably. Though the number of elected gov- shaping the incentives that face politicians, bureau- ernments grew significantly in the 1990s, the crats, and citizens remained in place. decade produced no clear evidence that elected Ad hoc incrementalism has also been problem- governments perform better in delivering policies atic. Many of the ad hoc reforms were symbolic, benefiting average citizens than do nonelected intended to preserve the old informal rules while ones. The experience did confirm, however, that pretending to reform. Some represented well-moti- relative to the situation in richer democracies, pri- vated attempts of individual or small groups of vate investors in most developing-country democ- reformers who,for lack of support,were undermined racies receive less enforcement of their contractual by jealousy, intrigue, or fatigue. More important, they and property rights, and average citizens are not as tended to be unrelated to a more coherent reform well treated by the state as special interests. strategy and thus over time many lost their steam. By the close of the 1990s, we had begun to An important general lesson is that technocratic understand the complicated interaction of formal responses to the governance crisis work only in very political institutions with informal rules and norms. auspicious settings—where there is committed Elected governments are most likely to make poli- leadership, a broad-based coalition in support of cies at the expense of the majority and in favor of reform, and sufficient capacity to carry the reform narrow segments of the population when citizens process forward. Clearly, these conditions exist in are badly informed about what government does, only a few developing countries, and rarely in those when political competitors cannot make credible that most need governance reform. promises to voters, and when society is polarized. State building is a complex process that requires Evidence shows that uninformed or polarized citi- time, leadership, and social capital. Governance zens and noncredible politicians undermine the reforms have to find a delicate balance consistent connection between voters and politicians in with the country’s politics, history, and culture.What democracies. Long-run economic growth and the may be needed are highly focused, pragmatic inter- provision of public goods are significantly higher in ventions that may be termed “strategic incremental- democracies with more credible politicians, better ism.”These interventions are opportunistic because informed citizens, and less social polarization. Non- they exploit the willingness to reform, but they are democracies vary substantially as well: those that grounded in political realities and consistent with have internal checks on the exercise of discretion the capacity constraints of the country concerned. by the executive seem to perform better, both in I N T RO D U C T I O N 25 terms of growth and public policy performance, implemented within a specific institutional, social, than others.The lesson here is that governments of and historic context. Recent economic and sector all kinds, elected or not, are most credible and most work at the World Bank already seeks to achieve a likely to respect property rights when they face better balance between country specificities and the checks and balances on their decision making. lessons from country experiences, but more is Another lesson of the 1990s is that policies fail needed fully to recognize that country-specific when citizens cannot hold politicians accountable market structures and institutions have a strong for poor performance and when governments can- influence on policy outcomes. In particular, this not make credible commitments. Credible, sustain- recognition calls for harder and more rigorous eco- able reform depends on the checks and balances nomic, institutional, and social analysis. provided through political institutions. In democ- Third, analytical work needs to change its orien- racies, checks and balances and elections prevent tation, away from seeking to assess how far policies arbitrary policy reversals by governments. But they diverge from optimality, to seeking to assess what are not the only means to hold governments policy and institutional conditions—for capital accountable: broad-based political parties can in accumulation, shared growth, productivity growth, some circumstances substitute for democratic and risk taking in a country-specific context—are checks and balances in one-party states. needed to set the growth process in motion. 5. Operational Implications For Strategy There is a need to rethink the focus of growth The complete operational implications of this study strategies and of development assistance. Up to still need to be fully developed. Some preliminary now, that focus has been on the nation state with ideas are outlined below. the implicit assumptions that (1) development outcomes within the boundaries of a nation state are homogeneous, and (2) all developing coun- For Analysis tries’ per capita incomes could and should con- On the analytical front, the first implication is the verge with those of industrialized countries.There need to redress the balance between analysis of pol- is now greater evidence and acknowledgment that icy instruments and analysis of strategies—understand- these two assumptions do not always hold. Con- ing strategies as coherent sets of actions that are vergence is much less a force now than anticipated intended to initiate and sustain growth. Over the a decade or more ago. Within countries such as years, in institutions such as the World Bank, the Brazil, China, and India, income differences across focus of research gradually has shifted away from regions are as large as income differences across country-specific growth experiences to focus countries, and even in relatively small Bolivia, increasingly on policies—trade, finance, macro, pri- income differences between the lowlands and the vatization to name a few—with secondary impor- highlands are large.This recognition implies a need tance given to country contexts.8 At the same time, to pay much greater attention to the forces driving outside the World Bank there has been increasing agglomeration and migration, both within and emphasis on individual country experiences (for across countries. example, Rodrik 2003b, and the research programs sponsored by the Global Development Network). The second implication is the need to recognize For Research country specificities in country economic analysis, On the research front, two issues in particular war- acknowledging that policies are conceived and rant further examination.The first relates to devel- 26 E C O N O M I C G ROW T H I N T H E 1 9 9 0 s opment agencies’ role in aid-dependent countries. For Behavior The agencies’ large role in financing the budget On the behavioral front, if solutions must be found has forced them to be involved in budget in specific-country contexts, rather than applied processes, weakening national decision making from blueprints, those who advise or finance devel- and rendering the concept of “ownership elusive oping countries will need more humility in their in practice” (Kwesi Botchwey,World Bank 2005a), approaches, implying more openness on the range particularly in aid-dependent Africa. Clearly, forms of solutions possible, more empathy with the coun- of engagement developed for project finance do try’s perspectives, and more inquisitiveness in assess- not apply to budget finance.There may be a need ing the costs and benefits of different possible to explore new approaches to the transfer of solutions. resources to these countries, rooted in public finance, such as those typically used in federated nations that have chosen rule-based, arms-length systems of transfers. Notes Second, the unit of analysis for economic and 1. See Country Note 3, “Poverty and Inequality: What social development has traditionally been the nation Have We Learned from the 1990s?” state, reflecting the assumptions (outlined above) 2. Countries successful at “converging” include most that nations are homogeneous and that all nations South Asian countries (Bangladesh, Bhutan, India, Nepal, Sri Lanka); many East Asian countries (China, would be able to catch up to the income levels of Indonesia, the Republic of Korea, Lao PDR, Malaysia, industrialized countries. There is a rich research Thailand, Vietnam); and Botswana, Chile, the Arab agenda on these assumptions that needs to be artic- Republic of Egypt, Lesotho, Mauritius, and Tunisia. See ulated. All nations may not succeed in reaching Country Note 2, “Lessons from Countries That Have industrialized countries’ income levels within a rea- Sustained Their Growth.” 3. This point of view was reinforced by the fiasco of the sonable time frame—partly because institutions can collapse of the Southern Cone stabilization programs take such a long time to develop, but also because of the late 1970s, in which strong currency apprecia- the economics of agglomeration and poles of devel- tions combined with rapid reductions in tariffs to cre- opment do not necessarily follow national bound- ate an adverse shock to industry, ultimately derailing aries. Research in this area may yield important the stabilization programs. Most analysts soon blamed implications for the role of nations and migration, the collapse on excessive speed, leading to faulty sequencing of the reform program: they argued that and also for the optimal degree of discretion regard- capital accounts had been liberalized too soon, without ing national policies. waiting until fiscal probity had been established and both trade and the domestic financial system had been successfully liberalized. For Operations 4. This study reviewed the growth experience of eight economies: China, Hong Kong (China), Indonesia, On the operational front, the recognition that not Japan, Korea, Malaysia,Taiwan,Thailand, and Singapore. everything needs to be right for growth to succeed, The report highlighted the variations in policy and and that partial success may sometimes be a more institutional environments under which these pragmatic goal than optimal policies, has obvious economies reached unprecedented rates of growth. It consequences for the type and extent of condition- emphasized that, with few exceptions, the state in the ality associated with development lending.Again in economies studied had taken an activist role to stimu- late risk taking in both the private and the public sector. this case, more rigorous economic analysis should It concluded that while highly successful in East Asia, help to distinguish what are binding constraints, the institutions needed for replicating this activist role and thus to inform decisions. The record suggests may not be present in other contexts. that forecasts need to be realistic and mindful of the 5. It has been argued, for example, that the increase in forces driving growth. India’s growth rate in the early 1980s was less the result I N T RO D U C T I O N 27 of the reforms introduced at that time than of the pri- mirror image of governance: bad governance invariably vate sector’s changing expectations regarding the leads to corruption; but corruption can likewise perpe- future—where the government was credible in ensur- trate bad governance. ing reduced expropriation risks and a more welcoming 7. The principal delegates the implementation of a task to environment (Rodrik and Subramanian 2004). an agent but must monitor the agent efficiently to 6. Public sector governance refers to how the state ensure that the task is accomplished. acquires and exercises the authority to provide and 8. A recent World Bank research project focusing on indi- manage public goods and services. Corruption, which vidual country experiences is Aid and Reform in Africa refers to the use of public office for private gain, is the (2001).
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