UCL ECON1005. THE WORLD ECONOMY. Hugh Goodacre. 9. POST WASHINGTON CONSENSUS.

1. UCL ECON1005. THE WORLD ECONOMY. Hugh Goodacre. 9. POST WASHINGTON CONSENSUS. • I. • Some negative experiences of the WC in practice. • II. • Theoretical criticisms of WC. • ‘Market failure': imperfect, incomplete and missing markets.

2. I • Some negative experiences of the WC in practice. • (1) Trade liberalisation not effective on its own; e.g. Mexico / NAFTA. • (2) Lack of capacity to benefit from opportunities. • (3) Tax, inequality and redistribution. • (4) Commodity TOT and pressure to export: fallacy of composition.

3. Some negative experiences of the WC in practice. • (1) Trade liberalisation not effective on its own. • Example: Mexico in NAFTA. Contrast China. • (2) Lack of capacity to benefit from opportunities. • EU, US open markets → little actual increase. • Lack of infrastructure: transport, information, credit. • (3) Tax, inequality and redistribution. • Trade liberalisation → increasing inequality. • Redistribution is costly and problematic: • Income taxes need advanced admin. infrastructure. • Border taxes more straightforward to collect. • Main tax revenue in Britain and US till 19th century.

4. Some negative experiences of the WC in practice, contd. • (4) Commodity TOT and pressure to export: fallacy of composition: • Structural adjustment → negative TOT effects: • All produce coffee → Pcoffee ↓ ! • TOT ≡ PX / PM • Example: • Xcoffee = 0.9 X • Mmachinery = 0.9 M • → TOT dominated by Pcoffee / Pmachinery

5. (4) Commodity TOT and pressure to export: fallacy of composition, contd • TOT dominated by Pcoffee / Pmachinery • Generalised: Pprimary commodities / Pindustrial products • TOT of primary exporters suffered drastic deterioration under SAPs. • Also adverse institutional effects: ‘Marketing boards’ and private monopolies.

6. (4) Commodity TOT and pressure to export: fallacy of composition, contd • ‘Prebisch-Singer Hypothesis’: e.g. Real agricultural raw material prices, 1968-2002. • Note decline from 1980s – dominance of WC.

7. II • Theoretical criticisms of WC. • ‘Market failure’: imperfect, incomplete and missing markets: • (1) Full employment assumption and development. • (2) Dynamic effects: comparative advantage can change. • (3) Externalities. • (4) Risk: lack of social safety net. • (5) Credit: asymmetrical information and credit rationing. • (6) Imperfect labour markets: wage inflexibility. • (7) The long-run / short-run distinction: ‘ hysteresis’.

8. ‘Post Washington Consensus’: • “Fifteen years after the Washington Consensus, the world has come to acknowledge that free trade is not a magic wand. • “Trade may be necessary for sustained industrial development, but it is not sufficient. • “In the right circumstances, trade liberalisation creates opportunities for development, but other factors determine the extent to which those opportunities are realised. • Stiglitz and Charlton (2006).

9. ‘Post Washington Consensus’, contd: • “In addition, any ‘gross’ welfare gains from trade liberalisation must be balanced against its associated costs. • “Liberalisation incurs adjustment costs as resources are moved from one sector to another in the process of reform and whereas it may take decades for multilateral trade reform to deliver gains to developing countries, the adjustment costs are automatic and usually upfront.” • Stiglitz and Charlton (2006).

10. Theoretical criticisms of WC: ‘Market failure’. • Classical ‘ initial assumptions’: • Perfectly-working markets with no unemployment. • Perfect information. • Perfect insurance / no risk. • Perfect competition. • Frictionless transfer of labour between different sectors.

11. Post Washington Consensus (Stiglitz, etc.): • Calls for return to ideas of Keynesian type: • Markets may not clear (i.e. ES = ED = 0) / may ‘fail’. • ‘Prices’ (P, W, r) may be ‘sticky’ / fail to adjust. • Market may reach equilibrium at a point where S ≠ D, i.e. ES, ED > 0. • → intervention necessary for social optimum. • Market failure theory: Markets may be • Imperfect • Incomplete • Missing.

12. Two traditions in macroeconomics

13. PWC: • Aim should be: • How to deal with market imperfections • No point imagining market can somehow be perfected. • ‘Endogenise’ imperfections / externalities within models. • Greenwald and Stiglitz 2005 as an example: • ‘Endogenises’ learning effects of industrialisation. • → Different conclusions from classical ones (dynamic > static).

14. PWC and market failure: • (1) The classical full employment assumption and development. • Ricardian (‘static’) TCA: • Advantages of redeploying resources / labour • FROM less efficient (and / or protected) • TO more efficient industries. • BUT: This requires ‘classical’ FE assumption!

15. (1) The classical full employment assumption and development, contd High u in many developing countries. → being laid off from low-productivity industry → not ‘redeployed’ at all, but unemployed / zero productivity! • i.e. Return to Keynesian critique: • ‘Static’ TCA “applicable to a special case only” / YFE.

16. (1) The classical full employment assumption and development, contd Even in industrialised countries, re-training, etc., little success: US: ‘Trade Adjustment Assistance’ (since 1962): tax concessions, job-finding assistance, etc. – little effect. UK: Decline of ‘old’ manufactures / mining, etc. BUT: The ‘new’ jobs (services) did not fit / redeployment impractical: Age, sex, skills, regional location. Problems of long term unemployment: Demoralisation. Obsolescence of skills / loss of TFP.

17. PWC and market failure: • (2) Dynamic effects: comparative advantage can change. • Static TCA failing to capture precisely what is most important about development?? • Example: Countries in East and South East Asia: • Static TCA → South Korea specialise in rice / industry not feasible. • i.e. CA can change / respond to developmentalist policy, etc. • → relevance of ‘dynamic’ comparative advantage.

18. PWC and market failure: • (3) Externalities. • Costs or benefits do not accrue to those conducting an activity: • Negative externalities: pollution, etc. • Positive externalities: • Activities benefit economy as a whole, but firm receives no reward. e.g. • Contributing to regional advantages (Marshall). • Training activities. • → Rationale for subsidy → increase ‘positive spillovers’ / reach social optimum.

19. → rationale for government intervention: • Remedy market failure by subsidizing investment. • → FF increase investment → socially optimal level: Even if not fully achieve social optimum, at least ward off effects of decreasing MPK / flatten PF to some extent.

20. PWC and market failure: • (4) Risk – incomplete / missing market: • WC emphasis on supposed efficiency gains of static CA. • But → risk of: • Collapse of local production under competition from cheaper imports. • New employment opportunities not yet open. • → Already high u rises even higher.

21. (4) Risk, contd • DCs: no ‘social safety net’ / UB, etc. • → majority potentially worse off with trade. → opposition to liberalisation / ‘globalisation’. • i.e. Markets ‘fail’; cannot internalise the costs of risk / firms have no motive to solve all this / ‘missing market’: • → Government action necessary on timing / ‘sequencing’: Protect employment until alternative available / allow time for retraining, etc.

22. PWC and market failure: • (5) Credit – another incomplete / missing market: • WC / classical approach: • Let firms internalise risk: • Firm borrows. • Rate of interest will reflect degree of risk. • i.e. Financial markets ‘clear’ through ‘price’ (of LF) mechanism. • BUT: • What if financial markets not functioning properly? • Imperfect information + enormous risk → private credit not available (even during global credit glut!).

23. Equilibrium credit ‘rationing’: • High loan rate (rL): • Credit-worthy borrowers are deterred. • High risk borrowers still apply. • Bank’s decision: • Maximise interest revenue. • BUT ALSO: minimise default risk, and the higher the rL the more the ‘mix’ of borrowers deteriorates! • → Optimum may be to ration credit rather than increase rL . • i.e. Credit market does not clear: • D > S; EDL not ‘choked off’ by rise in rL . • Market / ‘price mechanism’ has failed: • All agents optimising / a market equilibrium, etc., but sub-optimal.

24. rL QL Equilibrium credit rationing. Stiglitz and Weiss 1982. SL • rL ↑ → ‘mix’ of borrowers deteriorates / risk of default increases: • Credit-worthy borrowers increasingly deterred. • High risk borrowers continue to apply.

25. Equilibrium credit rationing, contd. rL Min default risk SL Max potential gross revenue rsafe EDL Credit rationed DL QL QLS QLD • ‘Price’ mechanism does not ‘choke off’ ED. • Market has failed – all agents optimizing, etc., but S ≠ D. • A market equilibrium – but sub-optimal.

26. PWC and market failure: (6) Imperfect labour markets. • WC / classical approach / u is because W downwardly-inflexible. PWC: such ‘imperfections’ endemic to markets anyway, labour market in particular. • → ‘New Keynesian’ explanation for W rigidity (Keynesianism on ‘microfoundations’). • e.g. ‘Efficiency Wage’ theory: • Firms choose to pay W > going rate • → motivate workers / reduce ‘turnover costs’ (hiring, firing, training). → Equilibrium where S ≠ D (here LS > LD). i.e. L market does not ‘clear ‘ through ‘price’ (here W) movements.

27. PWC and market failure: • (7) The long-run / short-run distinction again: ‘hysteresis’. • ‘New Keynesian’ argument: • Recovery from low points in the business cycle (‘SR’) is NOT a separate issue from increase in LR growth path. Recession → Unemployed workers lose skills, cease to look for work, etc. e.g. run-down of UK manufactures – regional effects, etc. i.e. SRvolatility ↓ can →LRgrowth ↑. And vice versa.

28. ‘Hysteresis’; effect of ‘fluctuations’ not ‘washed out’, but enduring.

29. The two main macroeconomic traditions – overview, • Classical economics. • Supply;laissez-faire; free trade– though protectionist challenge. • Post-war [Keynesian] consensus. • Demand, interventionism; tolerance of protection. i.e. critique of classical economics. • Washington [Classical] Consensus. • Supply, laissez-faire; free trade. i.e. classical revival. • Post Washington Consensus. • Supplyanddemand;market economyand some intervention (‘sequencing’, etc.); free tradeandsome protection. ‘Consensus’ between the traditions?

30. ‘Post Washington Consensus’: • “Fifteen years after the Washington Consensus, the world has come to acknowledge that free trade is not a magic wand. • “Trade may be necessary for sustained industrial development, but it is not sufficient. • “In the right circumstances, trade liberalisation creates opportunities for development, but other factors determine the extent to which those opportunities are realised. • Stiglitz and Charlton (2006).

31. ‘Post Washington Consensus’, contd: • “In addition, any ‘gross’ welfare gains from trade liberalisation must be balanced against its associated costs. • “Liberalisation incurs adjustment costs as resources are moved from one sector to another in the process of reform and whereas it may take decades for multilateral trade reform to deliver gains to developing countries, the adjustment costs are automatic and usually upfront.” • Stiglitz and Charlton (2006).

32. POST WASHINGTON CONSENSUS – summary. • Some negative experiences of the WC in practice. • (1) Trade liberalisation not effective on its own; e.g. Mexico / NAFTA. • (2) Lack of capacity to benefit from opportunities. • (3) Tax, inequality and redistribution. • (4) Commodity TOT and pressure to export: fallacy of composition. • Theoretical criticisms of WC. • ‘Market failure’: imperfect, incomplete and missing markets: • (1) Full employment assumption and development. • (2) Dynamic effects: comparative advantage can change. • (3) Externalities. • (4) Risk: lack of social safety net. • (5) Credit: asymmetrical information and credit rationing. • (6) Imperfect labour markets: wage inflexibility. • (7) The long-run / short-run distinction: ‘ hysteresis’.

33. Themes. • Keynesian critique of classical (micro / S-side) economics (“applicable to a special case only”). • ‘Consensus’ in today’s macro (‘New Keynesianism’, macro on ‘microfoundations’, etc.) likely to become fragile? • Validity of entire framework of today’s macro (Philips Curve, economic cycles, etc.) being tested in current conditions (emerging economies, financial implosion). • History of economic ideas is essential to assessing their analytical power. • Read the current press; textbooks inevitably a decade or more out of date.