Rethinking Development

1. Rethinking Development Joseph E. Stiglitz Bangalore January 2013

2. Brief review of development thinking • From projects to policies • The failure of the Washington Consensus policies • They were predicated on the notion that markets by themselves were efficient and stable, • and that the benefits of growth would trickle down to all citizens • Crisis has shown fallacy with these propositions • But from a developmental perspective, perhaps the greatest failing of the WC was just that: it was not concerned with development

3. From policies to institutions • Can’t be sure what constitutes good institutions • Crisis revealed deficiencies in US Central Bank and regulatory institutions • Countries without independent central banks performed better in crisis • Even if we did, we may not know how to create one. • Institutions, like markets (which can be thought of as a particular kind of institution), are instruments. They can be used to promote development or a “good society”, or to impede it. Details matter.

4. Political economy • Ideology served some special interests • Some gained from privatizations • Some gains from liberalization • Liberalization and privatization agendas were captured, just as regulatory (protectionist) agenda can be captured

5. A balanced role for government and markets • Work to improve performance of both • Large problems of corporate governance played major role in crisis • Major failure of government was not restraining markets • Waste of markets is greater than that associated with any democratic government • But government also has a positive role • Innovation • Catalytic • Developmental • Modern theory of market failures has helped clarify roles

6. The comprehensive approach to development • Single minded approaches won’t work • Need to have clear view of objectives • Beyond just GDP • Commission on the Measurement of Economic Performance and Social Progress explained why GDP was not a good measure • Inclusive (distribution), sustainable, democratic development focused on increasing well-being of all citizens

7. Rethinking Every Aspect of Policy in the Wake of the Crisis Macro: • Monetary policy old view: Ensuring low and stable inflation was necessary and almost sufficient for growth and stability governments should target inflation independent central banks best institutional arrangement

8. New view on monetary policy • More objectives: real stability, financial stability, growth, employment, and inflation • Single minded focus on inflation diverted attention from first order problems • Loss from crash was orders of magnitude greater than costs of inflation • Inflation targeting can be pro-cyclical with supply shocks • Need to design responses appropriate to source of shock • More instruments • Regulatory instruments (capital adequacy, macro-prudential regulations) just as important as interest rates • Independent central banks performed poorly

9. Other macro issues • Severe limitations on monetary policy • Poor monetary policies can cause crisis, but may not be able to restore economic strength • Understanding credit is essential • Transactions based demand for money inadequate basis for monetary policy • Central message of Greenwald and Stiglitz, Towards a New Paradigm • Real issue today is not zero lower bound, but break down of “transmission” mechanism, credit channel • Credit linkages, diversification may lead to more instability (Stiglitz, AER and JGD, 2010) (contrary to earlier view that diversification always lead to more stability) • Assumptions concerning convexity/concavity critical • Old models made strong and unrealistic assumptions without understanding import

10. Other macro issues • Constructing automatic stabilizers • Many reforms (moving from defined benefits to defined contribution pension systems) weakened automatic stabilizers • Countries with good social protections, welfare systems performed better (even if labor market seemed more “rigid”) • Flexible labor market not panacea

11. Macro models • Didn‘t predict crisis—most important economic event in three quarters of a century • Test of any science is prediction • Worse: Theory said “couldn’t happen” • Markets are rational • So bubbles can’t exist • Even after bubble broke, monetary authorities said effects were contained—they were wrong • Predictions again predicated on bad models

12. Macro models • Models provided little guidance on how to respond to crisis • Euro-crisis—another failure • Europe in double dip recession • Again, models failed in prediction • And many of the models have failed in prescription • Economies of Europe, US not likely to return to full employment any time soon • Resources today same as they were before the beginning of the recession • No good reason in standard theory that they should not be fully deployed • Waste amounts to trillions of dollars • Greater than the waste associated with markets in misallocation of capital before the crisis

13. Regulatory Policy • Old theory: • Could rely on self regulation • Least intrusive regulation as possible • Capital market liberalization • Financial market liberalization • Would lead to greater efficiency and stability • Capital flows would help stabilize

14. New Views • Self-regulation doesn’t work • Pervasive agency problems • Pervasive and deep externalities • Regulation has to be comprehensive—affecting incentives, structure, behavior • Capital flows are destabilizing—pro-cycle • Capital controls (capital account management) desirable • Financial market liberalization can be anti-growth and destabilizing • Less money to local SME’s

15. Trade Policy • Old trade-and-growth orthodoxy • Trade liberalization leads to more trade • More trade leads to more growth • Growth results in everyone being better off • New trade framework (i) Trade liberalization often does not lead to increased trade (ii) Trade liberalization may not lead to increased growth or increased welfare (iii) Trade-generated growth may not make everyone better off • There may be large losers • With imperfect risk markets, everyone could be worse off (Newbery-Stiglitz, 1982)

16. Industrial Policy Old view • Government shouldn’t interfere with markets • Government shouldn’t try to pick winners New View • Market failures are pervasive • They affect industrial structure • Governments should correct market failures • Not a matter of picking winners, but identifying externalities • Governments can’t avoid industrial policy • Implicit in budgetary policies • Implicit in legal frameworks • Development is about changing economic structure • Markets do a bad job in structural transformation

17. A Deeper Rethinking of Economics Old view • Individuals are fully rational • With well-identified preferences • Markets are competitive and well-functioning • Role of government is to enforce contracts and property rights

18. A Deeper Rethinking of Economics: new view • Pervasive irrationalities—but individual’s behavior is still predictable (systematic) • Pervasive information imperfections/asymmetries • Pervasive lack of competition • Preferences shaped by social context

19. Breaking down boundaries of social sciences • Behavioral economics—understanding psychological foundations of behavior • Sociology and economics—understanding the social formation of preferences and beliefs • And how they evolve over time • Social rigidities and social change • Concepts of race and caste • Law and economics • Law is more than just the enforcement of property rights and contracts • Has to be seen within a social context • Which is why legal transplants don’t work

20. These issues are especially important in development • Exciting time for development—rethinking all of premises