[OPE-L:2820] "What I learned at the World Economic Crisis" by Stiglitz

From: Gerald Levy (glevy@pratt.edu)
Date: Wed Apr 12 2000 - 01:09:30 EDT

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Date: Tue, 11 Apr 2000 23:02:35 -0500 (CDT)
From: "Harry M. Cleaver" <hmcleave@eco.utexas.edu>
Subject: AUT: Insider Economist on IMF & Crisis

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Date: Tue, 11 Apr 2000 15:52:53 -0700
From: Sid Shniad <shniad@sfu.ca>

The New Republic 04.17.00


The Insider

        By Joseph Stiglitz

Next week's meeting of the International Monetary Fund will bring to
Washington, D.C., many of the same demonstrators who trashed the World
Trade Organization in Seattle last fall. They'll say the IMF is arrogant.
They'll say the IMF doesn't really listen to the developing countries it
is supposed to help. They'll say the IMF is secretive and insulated from
democratic accountability. They'll say the IMF's economic "remedies" often
make things worse--turning slowdowns into recessions and recessions into

And they'll have a point. I was chief economist at the World Bank from
1996 until last November, during the gravest global economic crisis in a
half-century. I saw how the IMF, in tandem with the U.S. Treasury
Department, responded. And I was appalled.

The global economic crisis began in Thailand, on July 2, 1997. The
countries of East Asia were coming off a miraculous three decades: incomes
had soared, health had improved, poverty had fallen dramatically. Not only
was literacy now universal, but, on international science and math tests,
many of these countries outperformed the United States. Some had not
suffered a single year of recession in 30 years.

But the seeds of calamity had already been planted. In the early '90s,
East Asian countries had liberalized their financial and capital
markets--not because they needed to attract more funds (savings rates were
already 30 percent or more) but because of international pressure,
including some from the U.S. Treasury Department. These changes provoked a
flood of short-term capital--that is, the kind of capital that looks for
the highest return in the next day, week, or month, as opposed to
long-term investment in things like factories. In Thailand, this
short-term capital helped fuel an unsustainable real estate boom. And, as
people around the world (including Americans) have painfully learned,
every real estate bubble eventually bursts, often with disastrous
consequences. Just as suddenly as capital flowed in, it flowed out. And,
when everybody tries to pull their money out at the same time, it causes
an economic problem. A big economic problem.

The last set of financial crises had occurred in Latin America in the
1980s, when bloated public deficits and loose monetary policies led to
runaway inflation. There, the IMF had correctly imposed fiscal austerity
(balanced budgets) and tighter monetary policies, demanding that
governments pursue those policies as a precondition for receiving aid. So,
in 1997 the IMF imposed the same demands on Thailand. Austerity, the
fund's leaders said, would restore confidence in the Thai economy. As the
crisis spread to other East Asian nations--and even as evidence of the
policy's failure mounted--the IMF barely blinked, delivering the same
medicine to each ailing nation that showed up on its doorstep.

I thought this was a mistake. For one thing, unlike the Latin American
nations, the East Asian countries were already running budget surpluses.
In Thailand, the government was running such large surpluses that it was
actually starving the economy of much-needed investments in education and
infrastructure, both essential to economic growth. And the East Asian
nations already had tight monetary policies, as well: inflation was low
and falling. (In South Korea, for example, inflation stood at a very
respectable four percent.) The problem was not imprudent government, as in
Latin America; the problem was an imprudent private sector--all those
bankers and borrowers, for instance, who'd gambled on the real estate

Under such circumstances, I feared, austerity measures would not revive
the economies of East Asia--it would plunge them into recession or even
depression. High interest rates might devastate highly indebted East Asian
firms, causing more bankruptcies and defaults. Reduced government
expenditures would only shrink the economy further.

So I began lobbying to change the policy. I talked to Stanley Fischer, a
distinguished former Massachusetts Institute of Technology economics
professor and former chief economist of the World Bank, who had become the
IMF's first deputy managing director. I met with fellow economists at the
World Bank who might have contacts or influence within the IMF,
encouraging them to do everything they could to move the IMF bureaucracy.

Convincing people at the World Bank of my analysis proved easy; changing
minds at the IMF was virtually impossible. When I talked to senior
officials at the IMF--explaining, for instance, how high interest rates
might increase bankruptcies, thus making it even harder to restore
confidence in East Asian economies--they would at first resist. Then,
after failing to come up with an effective counterargument, they would
retreat to another response: if only I understood the pressure coming from
the IMF board of executive directors--the body, appointed by finance
ministers from the advanced industrial countries, that approves all the
IMF's loans. Their meaning was clear. The board's inclination was to be
even more severe; these people were actually a moderating influence. My
friends who were executive directors said they were the ones getting
pressured. It was maddening, not just because the IMF's inertia was so
hard to stop but because, with everything going on behind closed doors, it
was impossible to know who was the real obstacle to change. Was the staff
pushing the executive directors, or were the executive directors pushing
the staff? I still do not know for certain.

Of course, everybody at the IMF assured me they would be flexible: if
their policies really turned out to be overly contractionary, forcing the
East Asian economies into deeper recession than necessary, then they would
reverse them. This sent shudders down my spine. One of the first lessons
economists teach their graduate students is the importance of lags: it
takes twelve to 18 months before a change in monetary policy (raising or
lowering interest rates) shows its full effects. When I worked in the
White House as chairman of the Council of Economic Advisers, we focused
all our energy on forecasting where the economy would be in the future, so
we could know what policies to recommend today. To play catch-up was the
height of folly. And that was precisely what the IMF officials were
proposing to do.

I shouldn't have been surprised. The IMF likes to go about its business
without outsiders asking too many questions. In theory, the fund supports
democratic institutions in the nations it assists. In practice, it
undermines the democratic process by imposing policies. Officially, of
course, the IMF doesn't "impose" anything. It "negotiates" the conditions
for receiving aid. But all the power in the negotiations is on one
side--the IMF's--and the fund rarely allows sufficient time for broad
consensus-building or even widespread consultations with either
parliaments or civil society. Sometimes the IMF dispenses with the
pretense of openness altogether and negotiates secret covenants.

When the IMF decides to assist a country, it dispatches a "mission" of
economists. These economists frequently lack extensive experience in the
country; they are more likely to have firsthand knowledge of its five-star
hotels than of the villages that dot its countryside. They work hard,
poring over numbers deep into the night. But their task is impossible. In
a period of days or, at most, weeks, they are charged with developing a
coherent program sensitive to the needs of the country. Needless to say, a
little number-crunching rarely provides adequate insights into the
development strategy for an entire nation. Even worse, the
number-crunching isn't always that good. The mathematical models the IMF
uses are frequently flawed or out-of-date. Critics accuse the institution
of taking a cookie-cutter approach to economics, and they're right.
Country teams have been known to compose draft reports before visiting. I
heard stories of one unfortunate incident when team members copied large
parts of the text for one country's report and transferred them wholesale
to another. They might have gotten away with it, except the "search and
replace" function on the word processor didn't work properly, leaving the
original country's name in a few places. Oops.

It's not fair to say that IMF economists don't care about the citizens of
developing nations. But the older men who staff the fund--and they are
overwhelmingly older men--act as if they are shouldering Rudyard Kipling's
white man's burden. IMF experts believe they are brighter, more educated,
and less politically motivated than the economists in the countries they
visit. In fact, the economic leaders from those countries are pretty
good--in many cases brighter or better-educated than the IMF staff, which
frequently consists of third-rank students from first-rate universities.
(Trust me: I've taught at Oxford University, MIT, Stanford University,
Yale University, and Princeton University, and the IMF almost never
succeeded in recruiting any of the best students.) Last summer, I gave a
seminar in China on competition policy in telecommunications. At least
three Chinese economists in the audience asked questions as sophisticated
as the best minds in the West would have asked.

As time passed, my frustration mounted. (One might have thought that since
the World Bank was contributing literally billions of dollars to the
rescue packages, its voice would be heard. But it was ignored almost as
resolutely as the people in the affected countries.) The IMF claimed that
all it was asking of the East Asian countries was that they balance their
budgets at a time of recession. All? Hadn't the Clinton administration
just fought a major battle with Congress to stave off a balanced-budget
amendment in this country? And wasn't the administration's key argument
that, in the face of recession, a little deficit spending might be
necessary? This is what I and most other economists had been teaching our
graduate students for 60 years. Quite frankly, a student who turned in the
IMF's answer to the test question "What should be the fiscal stance of
Thailand, facing an economic downturn?" would have gotten an F.

As the crisis spread to Indonesia, I became even more concerned. New
research at the World Bank showed that recession in such an ethnically
divided country could spark all kinds of social and political turmoil. So
in late 1997, at a meeting of finance ministers and central-bank governors
in Kuala Lumpur, I issued a carefully prepared statement vetted by the
World Bank: I suggested that the excessively contractionary monetary and
fiscal program could lead to political and social turmoil in Indonesia.
Again, the IMF stood its ground. The fund's managing director, Michel
Camdessus, said there what he'd said in public: that East Asia simply had
to grit it out, as Mexico had. He went on to note that, for all of the
short-term pain, Mexico emerged from the experience stronger.

But this was an absurd analogy. Mexico hadn't recovered because the IMF
forced it to strengthen its weak financial system, which remained weak
years after the crisis. It recovered because of a surge of exports to the
United States, which took off thanks to the U.S. economic boom, and
because of NAFTA. By contrast, Indonesia's main trading partner was
Japan--which was then, and still remains, mired in the doldrums.
Furthermore, Indonesia was far more politically and socially explosive
than Mexico, with a much deeper history of ethnic strife. And renewed
strife would produce massive capital flight (made easy by relaxed
currency-flow restrictions encouraged by the IMF). But none of these
arguments mattered. The IMF pressed ahead, demanding reductions in
government spending. And so subsidies for basic necessities like food and
fuel were eliminated at the very time when contractionary policies made
those subsidies more desperately needed than ever.

By January 1998, things had gotten so bad that the World Bank's vice
president for East Asia, Jean Michel Severino, invoked the dreaded r-word
("recession") and d-word ("depression") in describing the economic
calamity in Asia. Lawrence Summers, then deputy treasury secretary, railed
against Severino for making things seem worse than they were, but what
other way was there to describe what was happening? Output in some of the
affected countries fell 16 percent or more. Half the businesses in
Indonesia were in virtual bankruptcy or close to it, and, as a result, the
country could not even take advantage of the export opportunities the
lower exchange rates provided. Unemployment soared, increasing as much as
tenfold, and real wages plummeted--in countries with basically no safety
nets. Not only was the IMF not restoring economic confidence in East Asia,
it was undermining the region's social fabric. And then, in the spring and
summer of 1998, the crisis spread beyond East Asia to the most explosive
country of all--Russia.

The calamity in Russia shared key characteristics with the calamity in
East Asia--not least among them the role that IMF and U.S. Treasury
policies played in abetting it. But, in Russia, the abetting began much
earlier. Following the fall of the Berlin Wall, two schools of thought had
emerged concerning Russia's transition to a market economy. One of these,
to which I belonged, consisted of a melange of experts on the region,
Nobel Prize winners like Kenneth Arrow and others. This group emphasized
the importance of the institutional infrastructure of a market
economy--from legal structures that enforce contracts to regulatory
structures that make a financial system work. Arrow and I had both been
part of a National Academy of Sciences group that had, a decade earlier,
discussed with the Chinese their transition strategy. We emphasized the
importance of fostering competition--rather than just privatizing
state-owned industries--and favored a more gradual transition to a market
economy (although we agreed that occasional strong measures might be
needed to combat hyperinflation).

The second group consisted largely of macroeconomists, whose faith in the
market was unmatched by an appreciation of the subtleties of its
underpinnings--that is, of the conditions required for it to work
effectively. These economists typically had little knowledge of the
history or details of the Russian economy and didn't believe they needed
any. The great strength, and the ultimate weakness, of the economic
doctrines upon which they relied is that the doctrines are--or are
supposed to be--universal. Institutions, history, or even the distribution
of income simply do not matter. Good economists know the universal truths
and can look beyond the array of facts and details that obscure these
truths. And the universal truth is that shock therapy works for countries
in transition to a market economy: the stronger the medicine (and the more
painful the reaction), the quicker the recovery. Or so the argument goes.

Unfortunately for Russia, the latter school won the debate in the Treasury
Department and in the IMF. Or, to be more accurate, the Treasury
Department and the IMF made sure there was no open debate and then
proceeded blindly along the second route. Those who opposed this course
were either not consulted or not consulted for long. On the Council of
Economic Advisers, for example, there was a brilliant economist, Peter
Orszag, who had served as a close adviser to the Russian government and
had worked with many of the young economists who eventually assumed
positions of influence there. He was just the sort of person whose
expertise Treasury and the IMF needed. Yet, perhaps because he knew too
much, they almost never consulted him.

We all know what happened next. In the December 1993 elections, Russian
voters dealt the reformers a huge setback, a setback from which they have
yet really to recover. Strobe Talbott, then in charge of the noneconomic
aspects of Russia policy, admitted that Russia had experienced "too much
shock and too little therapy." And all that shock hadn't moved Russia
toward a real market economy at all. The rapid privatization urged upon
Moscow by the IMF and the Treasury Department had allowed a small group of
oligarchs to gain control of state assets. The IMF and Treasury had
rejiggered Russia's economic incentives, all right--but the wrong way. By
paying insufficient attention to the institutional infrastructure that
would allow a market economy to flourish--and by easing the flow of
capital in and out of Russia--the IMF and Treasury had laid the groundwork
for the oligarchs' plundering. While the government lacked the money to
pay pensioners, the oligarchs were sending money obtained by stripping
assets and selling the country's precious national resources into Cypriot
and Swiss bank accounts.

The United States was implicated in these awful developments. In mid-1998,
Summers, soon to be named Robert Rubin's successor as secretary of the
treasury, actually made a public display of appearing with Anatoly
Chubais, the chief architect of Russia's privatization. In so doing, the
United States seemed to be aligning itself with the very forces
impoverishing the Russian people. No wonder antiAmericanism spread like

At first, Talbott's admission notwithstanding, the true believers at
Treasury and the IMF continued to insist that the problem was not too much
therapy but too little shock. But, through the mid-'90s, the Russian
economy continued to implode. Output plummeted by half. While only two
percent of the population had lived in poverty even at the end of the
dismal Soviet period, "reform" saw poverty rates soar to almost 50
percent, with more than half of Russia's children living below the poverty
line. Only recently have the IMF and Treasury conceded that therapy was
undervalued--though they now insist they said so all along.

Today, Russia remains in desperate shape. High oil prices and the
long-resisted ruble devaluation have helped it regain some footing. But
standards of living remain far below where they were at the start of the
transition. The nation is beset by enormous inequality, and most Russians,
embittered by experience, have lost confidence in the free market. A
significant fall in oil prices would almost certainly reverse what modest
progress has been made.

East Asia is better off, though it still struggles, too. Close to 40
percent of Thailand's loans are still not performing; Indonesia remains
deeply mired in recession. Unemployment rates remain far higher than they
were before the crisis, even in East Asia's best-performing country,
Korea. IMF boosters suggest that the recession's end is a testament to the
effectiveness of the agency's policies. Nonsense. Every recession
eventually ends. All the IMF did was make East Asia's recessions deeper,
longer, and harder. Indeed, Thailand, which followed the IMF's
prescriptions the most closely, has performed worse than Malaysia and
South Korea, which followed more independent courses.

I was often asked how smart--even brilliant--people could have created
such bad policies. One reason is that these smart people were not using
smart economics. Time and again, I was dismayed at how out-of-date--and
how out-of-tune with reality--the models Washington economists employed
were. For example, microeconomic phenomena such as bankruptcy and the fear
of default were at the center of the East Asian crisis. But the
macroeconomic models used to analyze these crises were not typically
rooted in microfoundations, so they took no account of bankruptcy.

But bad economics was only a symptom of the real problem: secrecy. Smart
people are more likely to do stupid things when they close themselves off

From outside criticism and advice. If there's one thing I've learned in
government, it's that openness is most essential in those realms where
expertise seems to matter most. If the IMF and Treasury had invited
greater scrutiny, their folly might have become much clearer, much
earlier. Critics from the right, such as Martin Feldstein, chairman of
Reagan's Council of Economic Advisers, and George Shultz, Reagan's
secretary of state, joined Jeff Sachs, Paul Krugman, and me in condemning
the policies. But, with the IMF insisting its policies were beyond
reproach--and with no institutional structure to make it pay
attention--our criticisms were of little use. More frightening, even
internal critics, particularly those with direct democratic
accountability, were kept in the dark. The Treasury Department is so
arrogant about its economic analyses and prescriptions that it often keeps
tight--much too tight--control over what even the president sees.

Open discussion would have raised profound questions that still receive
very little attention in the American press: To what extent did the IMF
and the Treasury Department push policies that actually contributed to the
increased global economic volatility? (Treasury pushed liberalization in
Korea in 1993 over the opposition of the Council of Economic Advisers.
Treasury won the internal White House battle, but Korea, and the world,
paid a high price.) Were some of the IMF's harsh criticisms of East Asia
intended to detract attention from the agency's own culpability? Most
importantly, did America--and the IMF--push policies because we, or they,
believed the policies would help East Asia or because we believed they
would benefit financial interests in the United States and the advanced
industrial world? And, if we believed our policies were helping East Asia,
where was the evidence? As a participant in these debates, I got to see
the evidence. There was none.

Since the end of the cold war, tremendous power has flowed to the people
entrusted to bring the gospel of the market to the far corners of the
globe. These economists, bureaucrats, and officials act in the name of the
United States and the other advanced industrial countries, and yet they
speak a language that few average citizens understand and that few
policymakers bother to translate. Economic policy is today perhaps the
most important part of America's interaction with the rest of the world.
And yet the culture of international economic policy in the world's most
powerful democracy is not democratic.

This is what the demonstrators shouting outside the IMF next week will try
to say. Of course, the streets are not the best place to discuss these
highly complex issues. Some of the protesters are no more interested in
open debate than the officials at the IMF are. And not everything the
protesters say will be right. But, if the people we entrust to manage the
global economy--in the IMF and in the Treasury Department--don't begin a
dialogue and take their criticisms to heart, things will continue to go
very, very wrong. I've seen it happen.

JOSEPH STIGLITZ is professor of economics at Stanford University (on
leave) and a senior fellow at the Brookings Institution. From 1997 to
2000, he was chief economist and vice president of the World Bank. He
served on the president's Council of Economic Advisers from 1993 to 1997.

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